**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20549**

 

**FORM 10-K**

 

**x****  Annual Report Pursuant toSection 13 or 15(d)of the Securities Exchange Act of 1934**

 

**Transition Report Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934**

 

**FOR THEFISCAL YEAR ENDED DECEMBER 31, 2003**

 

**COMMISSIONFILE NUMBER**

**0-32667**

 

**CAP ROCK ENERGY CORPORATION**

 
| **Texas**                                                |   | **75-2794300**                        |
|----------------------------------------------------------|--------|---------------------------------------|
| (State  of Incorporation)                                |   | (I.R.S.  Employer Identification No.) |
|                                                     |   |                                  |
| **500 West Wall Street, Suite 400**                      |   |                                  |
| **Midland, Texas**                                       |   | **79701**                             |
| (Address  of principal executive office)                 |   | (Zip  Code)                           |
|                                                     |   |                                  |
| Registrant’s  telephone number, including area code |   | **432-683-5422**                      |

 

Securities registeredpursuant to Section 12(b) of the Act:

 
| **Title of Each  Class**                     |   | **Name of each exchange on which  registered** |
|----------------------------------------------|--------|------------------------------------------------|
|                                         |   |                                           |
| **COMMON  STOCK, PAR VALUE  $.01 PER SHARE** |   | **AMERICAN STOCK EXCHANGE**                    |

 

Securities registeredpursuant to Section 12(g) of theAct:                         **NONE**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

| Yes | ý | No | o |
|-----|--------|----|---|

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K.  ý

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act).

 

| Yes | o | No | ý |
|-----|---|----|--------|

 

**THE AGGREGATE MARKET VALUE OF THE COMMONSTOCK HELD BY NON-AFFILIATES OF THE REGISTRANT AS OF JUNE 30, 2003, WASAPPROXIMATELY $22,890,307 BASED ON THE CLOSING PRICE OF $17.59 FOR THE COMMONSTOCK ON THE AMERICAN STOCK EXCHANGE AS REPORTED BY THE WALL STREET JOURNAL.**

 

**THE NUMBER OF SHARES OF COMMON STOCKOUTSTANDING ON MARCH 22, 2004, WAS 1,567,725.**

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

**Portions of the Registrant’s definitive ProxyStatement for the 2004 annual meeting of its shareholders, which will be filedwith the Commission not later than April 29, 2004, are incorporated byreference into Part III of this report.**

 

 

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**PART I**

 

**ITEM 1. BUSINESS**

 

**The Company**

 

CapRock Energy Corporation, its subsidiaries, and affiliates (the “Company”) ownand operate an electric distribution and transmission business in variousnon-contiguous areas in the State of Texas. The Company’s objective has always been to provide quality customerservice.  The Company’s primary focus ison the distribution of electricity to its customers, from the use of its powerlines and associated equipment.  Allcosts of purchased power, including the cost of fuel used to generate thepower, are passed through to the retail customer.  The Company has not and does not plan to engage in the generationof electricity.  The Company provideselectric distribution service to approximately 35,000 meters in 28 countiescovering approximately 13,000 square miles in Texas. This includes 23,000meters in 17 counties within two operating divisions in the Midland-Stantonarea of west Texas (the “west Texas divisions”), 6,100 meters in the centralTexas area around Brady, and over 4,200 meters in northeast Texas in Hunt,Collin and Fannin Counties.  The Companyalso provides management services to the Farmersville Municipal Electric Systemwhich services nearly 1,500 meters in Farmersville, Texas.  No one customer accounted for more than 10%of the Company’s electric revenues during any of the periods presented.

 

TheCompany was formed in December 1998 in accordance with a conversion planadopted by the members of the Company’s predecessor, Cap Rock ElectricCooperative, Inc. (the “Cooperative” or the “Predecessor”), which wasincorporated as an electric cooperative in the State of Texas in 1939.  The conversion plan provided a method forchanging the corporate structure from a member owned cooperative to ashareholder owned corporation. The conversion plan provided for the transfer ofall of the Cooperative’s assets and liabilities to the Company. It alsoprovided for the payment of the equity accounts and membership interests, ifany, of members of the Cooperative through discounted cash, credit on theirelectric bill over a 24 month period, or common stock in the Company, at themember’s option.  All of theCooperative’s assets were transferred to the Company in accordance with theconversion plan and the Company assumed all of the Cooperative’s liabilities inearly 2002.  The Certificate ofConvenience and Necessity (“CCN”), which allows a company to provide electricutility services within a certified territory in Texas, was transferredeffective September 1, 2003.  OnFebruary 8, 2002, the Company issued common stock to all former members ofthe Cooperative who chose stock as the method of payment for their equity andmembership interest, if any, in the Cooperative. Payments were completed bylate 2001 for members who chose the discounted cash payment option.  The former members who chose credits ontheir electric bill have received those credits, with such credits being fullyapplied by the end of 2003.

 

**Electric Market**

 

Inthe United States, revenues from sales of electricity to ultimate consumerstotal over $250 billion per year.  It isan industry which is undergoing many changes. Deregulation occurred in Texasbeginning in 2002, giving rise to significant opportunities and challenges forthe Company.  While the Company is notcurrently participating in competition as provided for in the 2000 legislation,it has operated in dually certified areas since its existence.  Now that the Company is regulated by thePublic Utility Commission of Texas, it will be required to comply with theprovisions of the 2000 legislation in the future.  See State and Federal Regulation – *State Regulation*.  The Company plans to continue to concentrateon customer service as a distribution, or wires, company rather than beingheavily involved in the higher risk business of power supply.  Therefore, the Company will not face thesame risks, such as loss of customers due to customer choice, that other retailelectric providers face.  Rather theCompany will continue to serve its customers by delivering electric energy toits customers over its lines regardless of where the energy is purchased.

 

Manyelectric utility companies may not be able to meet the demands of a newlycompetitive marketplace due to their size or lack of expertise.  The Company has experience serving customersin more sparsely

 

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populatedareas, a majority of which are dually certified with another utility.  This experience in a competitive marketplacegives the Company an advantage over other similar sized electricutilities.  The Company expects that ascompetition becomes more intense and operations become more complicated, moreand more small to medium sized electric utility businesses will want to divesttheir electric systems for some of the same reasons that the Company convertedfrom a member owned cooperative association to a shareholder owned businesscorporation.

 

Inaddition to the small to medium sized electric utility businesses that may belooking to divest their operations, Management believes many of the largershareholder owned electric utilities have been cutting costs by closing servicecenters in smaller communities and becoming more impersonal with their customers.Management of the Company believes these electric utilities are concentratingtheir efforts in the large urban populations and some may be looking to divesttheir holdings in rural and less populated suburban areas. See also“Business-Business Strategy.”

 

**Business Strategy**

 

TheCompany’s primary focus has been quality customer service.  Management plans to continue that focus asit implements a long term strategy of acquiring customers in various locationsand regions across the United States for its electric distribution business.The Company believes that mergers and acquisitions will help it increase itscustomer base and thus put it in a position to compete effectively in aderegulated marketplace.

 

TheCompany’s objective is to become a national electric distribution company withcommunity-focused local operating divisions.  The strategy is to grow byacquiring small to medium sized electric distribution businesses in rural areasthat have the potential for growth.

 

Atthe present time, the Company’s largest service area is in west Texas, where itprimarily serves residential customers, ranching customers and the oil and gasindustry. In the case of the oil and gas industry, the Company’s revenues arenot significantly affected by normal fluctuations in the price of oil andgas.  The Company’s revenues areaffected by the weather, economy and other conditions in its service areas,circumstances that are not unusual for a local distribution company.  The Company believes that it needs todiversify its customer base so that it is not dependent on any one area interms of economy and weather. The Company believes that its strategy ofacquiring electric distribution companies in various locations and regionsacross the United States is the best way for it to achieve this objective.

 

Thelarger electric utilities have traditionally been in urban areas with the mostmeters per mile of electric line. These are usually found in or around largecities and other metropolitan areas. The small to medium sized electricdistribution businesses, on the other hand, are generally located inless-populated suburban and rural areas where there are fewer meters per mileof electric line and where the cost of service per meter is therefore greater.In the past, the larger utilities have, for the most part, viewed the areaswhere these small to medium sized electric distribution businesses operate asmarginal because these service areas generally do not provide the net revenuesper dollar of investment that the larger utilities have come to expect. TheCompany therefore believes that as the electric utility industry continues toconsolidate, the opportunity to acquire electric distribution businesses inless populated suburban and rural areas will remain below the economic thresholdof many of the Company’s larger competitors, yet these areas would provide theCompany with a significant opportunity to grow and diversify.

 

TheCompany’s business strategy is a continuation of the former Cooperative’ssuccessful history of growing through acquisitions. Management believes that ithas the experience to consolidate these small to medium sized electricdistribution businesses and to meet the management challenges of successfullyoperating these geographically diverse businesses once they have been acquired.The basis for this belief is that the Company has successfully combined, and iscurrently operating, three former electric distribution cooperatives, which arenow divisions of the Company. The most distant of these divisions is over 450miles from the Company’s corporate headquarters in Midland, Texas. The Companyalso currently provides management services to a municipal utility in NorthTexas.  See also Note 23 to theconsolidated financial statements, “Commitments and Contingencies,” related tothe unsuccessful acquisition of the Lamar Cooperative.

 

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**Seasonal Nature of Business**

 

TheCompany’s operating revenues come from electric or electric related sales.Annual sales for 2003 to the Company’s commercial/industrial, residential andirrigation customers accounted for approximately 52%, 41%, and 7%,respectively, of total electric sales. This trend has remained fairly constant.

 

Commercialand industrial revenues, derived primarily from electric powered oilfieldequipment, are generally not subject to seasonal fluctuation, or normal oilprice fluctuations. This is because many producers have pre-committed theiroutput.  Electric power requirementscan, however, be affected by a dramatic change in the price of oil, whichaffects the overall market for oil.  Oiland gas prices have risen over the past few years.  Oilfield activity, and thus electric demand and consumption, mayincrease because of new drilling programs and the resulting new production.

 

Residentialsales vary with temperature fluctuations, primarily during the summer months,as the Company’s residential customers use more electric power for coolingduring the hot summer months. Historically, approximately 33% of the Company’sannual residential sales occur during the period July 1 toSeptember 30.

 

Irrigationrevenues, derived primarily from cotton farmers with electric poweredirrigation equipment, are subject to temperature and rainfall fluctuationsduring the cotton planting and growing seasons. Although irrigation sales areonly 7% of all electric sales, approximately 70% of those irrigation salesoccur during the period April 1 to September 30.

 

**Non-Electric Business Investments**

 

TheCompany has investments in the real estate business, the oil and gas businessand the petroleum distribution business, none of which separately orcollectively account for 10% or more of the Company’s revenues. See Notes 9 and11 to the consolidated financial statements.

 

Inthe past, the Company invested in the oil and gas exploration and productionbusiness.  In December 2000, theCompany merged its mineral and royalty company with another company withsimilar goals. The merged company, Map Resources, Inc. (“MAP”), owns oil andgas minerals and royalties and some non-operated working interests. The Companyaccounted for its 42% interest in MAP using the equity method ofaccounting.  Effective October 8,2003, the Company reached an agreement with MAP to sell its entire interest inexchange for a note receivable of $1,250,000 due in October 2004.

 

TheCompany has a 10% interest in United Fuel and Energy Company (“United Fuel”),which is engaged in the petroleum distribution business, with a right toacquire an additional 10% interest.  InJanuary 2001, the Company acquired an additional 5% interest in UnitedFuel from certain selling shareholders of United Fuel, giving the Company a 15%interest in the petroleum distribution company.  The Company has a right to acquire up to 25% of the stock of UnitedFuel.  The Company also had a notereceivable from United Fuel which was extinguished by United Fuel taking theCompany’s position as borrower on a cross-collateralized note payable.  The Company is a secondary guarantor onUnited Fuel’s note of $3,500,000.  InMarch 2004, the Company signed an agreement with a shareholder of United Fuelto sell its shares of stock. Consummation of the sale is contingent upon certain future events, suchas United Fuel's capitalization arrangements. See Notes 8 and 14 to the consolidated financial statements.

 

TheCompany’s real estate investments consist primarily of an office building andthe associated land. The Company is also an investor in certain limitedpartnerships which own and operate interests in real properties.  The real estate partnerships were sold inFebruary 2004.  See “Properties”for additional information.

 

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**Employees**

 

Asof December 31, 2003, the Company had 112 full-time and two part-timeemployees, none of which were members of any labor unions.

 

**State and Federal Regulation**

 

*State Regulation*

 

Asa Texas electric utility, we are subject to the jurisdiction of the PublicUtility Commission of Texas (“PUCT”), which has general regulatory authorityover our rates, our certificated territory, and the sale of certainfacilities.  At thetime of the Company’s conversion from an electric cooperative to an investorowned electric utility, the Texas Public Utility Regulatory Act (“PURA”)provided that a successor to an electric cooperative, such as the Company,would be treated as a cooperative for regulatory purposes. This would haveallowed the Board of Directors of the Company to continue to set the rates thatit charges its customers and to decide when and if to enter into competition.However, during the 2003 Texas legislative session, Senate Bill 1280 (“SB1280”) was adopted which amended the PURA so that the Company would be treatedas an investor owned utility subject to regulation by the PUCT.  The Company’s rates are now subject toregulation and approval by the PUCT, rather than the Company’s Board ofDirectors, and the PUCT will determine how and when the Company will enter intocompetition.  In accordance with thischange in the PURA, the Company filed its electric service tariffs with thePUCT in September 2003.  The PUCTis currently reviewing those tariffs. In addition, the PUCT initiated an inquiry to determine thereasonableness of the Company’s electric rates and required the Company to submita standard rate filing package.  TheCompany submitted that rate filing package in late February 2004.

 

*Federal Regulation*

 

Asubsidiary of the Company, NewCorp Resources Electric Cooperative, Inc.(“NewCorp”) owns the transmission system that serves the west Texas divisionsand is subject to the jurisdiction of the Federal Energy Regulatory Commission(“FERC”).  FERC has authority overwholesale sales of electricity, the transmission of electric power, maintenanceof accounting records in accordance with the uniform system of accounts and theissuance of certain securities.  TheCompany is exempt from all provisions of the Public Utility Holding Company Actof 1935, except Section 9(a)(2), which relates to the acquisition of thesecurities of other utilities.  See alsoNote 23, “Commitments and Contingencies,” to the consolidated financialstatements.

 

The1992 Energy Policy Act began deregulating the electricity market forgeneration.  The Energy Policy Actpermitted FERC to order electric utilities to allow third parties to use theirtransmission systems to sell electric power to wholesale customers.  In 2003, NewCorp applied for and receivedpermission from FERC to charge open access transmission system rates forwholesale transactions.  FERC also requiresthe Company to provide transmission services to others under terms comparableto those we provide ourselves.  InDecember 1999, FERC issued an order (FERC Order No. 2000) encouragingformation of regional transmission organizations (RTOs).  RTOs are designed to control the wholesaletransmission services of the utilities in their regions, thereby facilitatingopen, and more competitive, markets in bulk power.  In February of 2004, FERC issued an order granting RTOstatus to the Southwest Power Pool (“SPP”).

 

TheCompany and all other electric utilities with interstate transmissionfacilities operate under FERC regulated open access tariffs that offer allwholesale buyers and sellers of electricity the same transmission services, atthe same rates, that the utilities provide themselves.  Our 305 mile transmission system that servesthe west Texas divisions is currently in the SPP.  Our 18 mile intrastate transmission system that serves theoperating division in central Texas is in the Electric Reliability Council ofTexas (“ERCOT”).  Management believesthat FERC Order No. 2000 and continued participation in the SPP and ERCOT willnot have a material effect on its operations.

 

**Competition and Restructuring in the Utility Industry**

 

TheCompany faces competition in providing electric distribution services. Many ofthe Company’s competitors, like TXU Energy and its affiliate, Oncor, are muchlarger than the Company and have financial resources that

 

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aremuch greater than the Company’s.  Oncor,which is the largest electric utility in the State of Texas in terms ofrevenues and size of operating areas, is certified to operate in many of theareas in west Texas where the Company currently operates, and the Companycompetes with it on the basis of price and service. In some cases, theCompany’s prices are higher than those of Oncor and other retail electricproviders, but the Company believes that it has retained many of its customersdespite its prices because of the quality of the services it provides.

 

Legislationpassed in Texas in 1999, which became effective January 2002, willsignificantly modify the industry and potentially introduce more competitioninto the Texas retail market.  In thefuture, the Company’s customers may be able to purchase electricity from otherproviders, however, the Company will continue to provide distribution servicesand receive a wires charge.  See“Business-State and Federal Regulation.”

 

Federallegislation, such as the Public Utility Regulatory Policy Act of 1978 and, morerecently, the National Energy Policy Act of 1992 and Texas legislation, such asthe Public Utility Regulatory Act of 1995, as amended, have significantlyaltered competition in the electric utility industry. Among other things, thePublic Utility Regulatory Policy Act and the National Energy Policy Actencourage wholesale competition among electric utility and non-utility powerproducers. The National Energy Policy Act addresses a wide range of energyissues and is intended to increase competition in electric generation andbroaden access to electric transmission systems. At the state level, the PublicUtility Regulatory Act encourages greater wholesale competition, flexibleretail pricing and requires the PUCT to report to the Texas legislature oncompetition in electric markets.  TheCompany does not engage in the power generation business.

 

TheNational Energy Policy Act empowers the Federal Energy Regulatory Commission torequire utilities to provide transmission facilities for the delivery ofwholesale power from other power producers to qualified resellers, such asmunicipalities, cooperatives and other utilities. The Company’s transmissionfacilities in its west Texas divisions, which are in the Southwest Power Pool,are subject to regulation by the Federal Energy Regulatory Commission, and theCompany’s transmission facilities in its central Texas division, which are partof the Electric Reliability Council of Texas, Inc., are subject to regulationby the PUCT. During 2002, the Company applied for, and FERC approved, theunbundling of transmission rates relating to its west Texas transmissionsystem.

 

**Power Requirements**

 

TheCompany purchases power for resale to its retail customers from wholesalesuppliers and distributes that power to its customers over approximately 320miles of transmission lines and approximately11,000 miles of distributionlines.  The Company’s transmissionsystems interconnect with the systems of power suppliers and other utilities,to permit bulk power transactions with other electricity suppliers. TheCompany, through NewCorp, owns and operates a 305 mile transmission system thatsupplies wholesale power to the Company’s west Texas divisions.  NewCorp is a part of the Southwest Power Pool.  SPP coordinates transmission services amongits members.  In 2003, the Companypurchased all electric power pursuant to wholesale electric power contractswith Southwestern Public Service Company (“SPS”), Lower Colorado RiverAuthority  (“LCRA”) and Garland Powerand Light (“Garland”), which accounted for approximately 74%, 14% and 12%,respectively, of the electric power purchases of the Company. Generally, thewholesale electric power supply contracts are based on fixed charges for kWhusage, transportation and auxiliary services and a variable charge for fuelbased on kWh usage. The Company’s purchased power costs fluctuate primarilywith the price of natural gas. The contracts with SPS and LCRA expire in 2013and 2016, respectively.  The contract withGarland had an expiration date of 2004, but has been extended until 2005.  We cannot predict what effect, if any,renegotiation of future expiring contracts may have on the Company’s financialcondition and results of operations. However, there is adequate supply of powerand generation within the region should the Company need alternative powersupplies.  All costs associated withpurchased power are passed through to the retail customer.  For additional discussion of our businesssegment see “Non-Electric Business Investments” and Note 23 to the consolidatedfinancial statements.

 

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**Environmental Matters**

 

TheCompany is subject to federal and state regulations with respect to certainenvironmental matters.  The Company isunaware of any present or potential environmental problems and believes it isin compliance with all environmental regulations.  The laws applicable to environmental concerns can change rapidlyand are difficult to predict. Substantial expenditures may be required tocomply with these ever changing regulations. The Company analyzes the potentialcosts arising from environmental matters on an ongoing basis.

 

**Construction and Capital Requirements**

 

TheCompany has no major construction projects planned at the present time. Utilityconstruction expenditures for 2004 will consist primarily of costs to maintainthe Company’s transmission and distribution systems. Total gross propertyadditions, including construction work in progress, for the years endedDecember 31, 2003 and 2002, and the nine months ended December 31,2001, were $5,209,000, $1,517,000, and $4,257,000, respectively.  Management’s planned capital expendituresfor the next 12 months are $4,600,000.

 

**Company Website**

 

TheCompany’s website address is www.caprockenergy.com.  TheCompany’s reports on Form 10-K and quarterly reports on Form 10-Q are availablefree of charge at this website.  Thesereports are made available on the website as soon as practicable after filingwith, or furnishing to, the Securities and Exchange Commission.

 

**ITEM 2. PROPERTIES**

 

Transmissionsystems normally carry high voltage electricity over long distances, whereasdistribution lines carry lower voltage power from a substation tocustomers.  The transmission system thatserves the west Texas divisions consists of 16 substations and 305 miles ofsingle pole transmission line that was constructed over a period of severalyears between 1975 and 1995.  The systemprovides a looped transmission line at 138 kV that provides for two electricsupply delivery points for power providers to tie into and deliver power.  All substation structures and equipment arerelatively new and utilize modern technologies.  The substations and transmission lines are controlled by aSupervisory Control and Data Acquisition (“SCADA”) system, which allows formonitoring of voltage and current, and assists in operations.  All present substation transformers havein-service dates between 1975 and 1995. The 16 substations supply sixty-six distribution line circuits, whichserve over 9,800 miles of primary and secondary distribution line in 17countywide areas and supplies approximately 120 MW of peak electricalpower.  When the transmission system wasbeing constructed, a large portion of the distribution system was rebuilt toaccommodate the new substations, as well as new feeder circuits beingconstructed with larger conductors and a higher distribution voltage.  Many of the distribution circuits can alsobe fed from alternative substations in order to minimize outage time.  The distribution system also utilizes aSCADA system.

 

TheCompany also owns a 45,000 square foot office building located in Midland,Texas, that is used as its general corporate headquarters. The Company occupiesapproximately 35% of the building and the remainder is leased to commercialtenants. In addition to the office building, the Company owns other real estaterelated to its electric distribution business, including right-of-ways,easements and land where substations, transmission and distribution lines arelocated, and division office locations in Stanton, Colorado City, Brady andCeleste, Texas.

 

**ITEM 3. LEGAL PROCEEDINGS**

 

Thereis no other litigation pending or threatened against the Company, other thancertain legal proceedings arising in the ordinary course of business, none ofwhich are expected to have a material impact on the Company’s financialcondition, operating results or liquidity.

 

SeeNote 23, “Commitments and Contingencies,” to the consolidated financialstatements.

 

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**ITEM 4.  SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS**

 

Therewere no matters submitted to a vote of security holders during the fourthquarter of 2003.

 

**Executive Officers of the Registrant**

 

The executive officers ofthe Company are as follows:

 
| **NAME**            |   | **AGE** |   | **POSITION**                                                     |
|---------------------|--------|---------|--------|------------------------------------------------------------------|
| David  W. Pruitt    |   | 57      |   | Co-Chairman  of the Board, President and Chief Executive Officer |
|                |   |    |   |                                                             |
| Ulen  A. North. Jr. |   | 58      |   | Executive  Vice President                                        |
|                |   |    |   |                                                             |
| Lee  D. Atkins      |   | 60      |   | Senior  Vice President, Chief Financial Officer and Treasurer    |
|                |   |    |   |                                                             |
| Sammy  C. Prough    |   | 53      |   | Vice  President and Chief Operating Officer                      |
|                |   |    |   |                                                             |
| Ronald  W. Lyon     |   | 48      |   | Vice  President, General Counsel and Secretary                   |
|                |   |    |   |                                                             |
| Celia  A. Zinn      |   | 55      |   | Vice  President, Controller and Assistant Secretary/Treasurer    |

 

*David W.Pruitt* has servedas President and Chief Executive Officer of the Company since its inception andas Co-Chairman of the Board since February 2001.  He served in those same positions for the Cooperative from 1987until its dissolution in 2004.

 

*Ulen A. North,Jr*. hasserved as Executive Vice President of the Company since its inception.  He served in that same position for theCooperative from December 1996 until its dissolution in 2004.

 

*Lee D. Atkins*has served as Senior Vice President and Chief Financial Officer of the Companysince September 2001, and Treasurer since August 2002. He served asExecutive Vice President/Chief Financial Officer of RedMeteor.com, Inc. fromAugust 2000 until September 2001, and as Vice President/CFO of CSWEnergy from February 1992 until August 2000.

 

*Sammy C.Prough* has servedas Vice President and Chief Operating Officer of the Company since itsinception.  He served in the sameposition for the Cooperative from June 1999 until its dissolution in 2004.

 

*Ronald W*.*Lyon* has served as Vice Presidentand General Counsel of the Company since October 2001, and Secretary sinceAugust 2002. Prior to that he was engaged in the private practice of lawand served as full-time general counsel to the Cooperative from 1993 until itsdissolution in 2004.

 

*Celia A. Zinn*joined the Company as Controller in July 2001, and was elected to serve asAssistant Secretary/Treasurer in August 2002, and Vice President inDecember 2002.  She previouslyserved as Senior Vice President and Controller of Costilla Energy, Inc. fromApril 1996 until July 2001. Ms. Zinn is a certified public accountant.

 

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**PART II**

 

**ITEM 5.  MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

**Market Information and Holders of Common Stock**

 

TheCompany’s common stock was initially issued on February 8, 2002, and begantrading on the American Stock Exchange on March 14, 2002, under the symbol“RKE.”   The following table sets forththe range of high and low sales prices per share of common stock for theperiods shown, as reported in the consolidated reporting system of the AmericanStock Exchange.  Because the stock wasnot issued and distributed to former members of the Cooperative untilFebruary 8, 2002, and the stock was not listed on the exchange untilMarch 14, 2002, there was no previous market for the shares.

 

|              |   | **2003** |       | **2002** |       |
|-------------------|--------|----------|------------|----------|------------|
| **Quarter ended** |   | **High** |       | **Low**  |       | **High** |   | **Low** |   |
|              |   |     | ** ** |     | ** ** |   | ** ** |   | ** ** |
| December 31  |   | $        | 32.99      |     | $          | 27.85 |   | $ | 11.65 |   | $ | 10.10 |   |
| September 30 |   | 35.50    |       | 17.51    |       | 12.35 |   | 11.25 |   |
| June 30      |   | 21.50    |       | 10.35    |       | 12.60 |   | 7.20 |   |
| March 31     |   | 11.85    |       | 10.25    |       | — |   | — |   |
|                   |        |          |            |          |            |  |  |  |  |  |  |  |  |

 

Asof March 22, 2004, there were 12,312 holders of record of the Company’scommon stock.

 

**Dividend Policy**

 

Atthe present time, the Company has not issued preferred stock.  The Company has notdeclared or paid dividends on its common stock to date, and does not anticipatepaying dividends in the foreseeable future. Any dividends declared would be subject to the prior rights of holdersof any outstanding cumulative preferred stock. Certain Company loan documentsrestrict the Company’s payment of dividends.

 

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**ITEM 6. SELECTED FINANCIAL DATA**

 

**SELECTED CONSOLIDATED FINANCIAL DATA**

 

Thefollowing table sets forth selected consolidated financial statementinformation for the years ended December 31, 2003 and 2002, nine monthsended December 31, 2001 and 2000, and the years ended March 31, 2001and 2000.  The following selectedconsolidated financial data should be read in conjunction with Item 7,“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and Item 8, “Financial Statements and Supplementary Data.”

 
|                                                             |   | **YEARS ENDED  DECEMBER 31,**                                                                                                                                                                                                           |    | **NINE MONTHS  ENDED  DECEMBER 31,** |       | **YEARS ENDED  MARCH 31,** |       |
|------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------|-------------------------------------------|------------|---------------------------------|------------|
|                                                             |   | **2003**                                                                                                                                                                                                                                     |    | **2002**                                  |       | **2001 (2)**                    |       | **2000** |   | **2001** |   | **2000(1)** |   |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       | **(UNAUDITED)** |   |   |   |   |   |
|                                                             |   | **— — — — — — — —  — — — — — — — (Thousands of dollars)— — — — — — — — — — — — — — —** |    |
| **CONSOLIDATED STATEMENTS OF OPERATIONS DATA:**                  |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| Operating  revenues                                              |   | $                                                                                                                                                                                                                                            | 82,852  |                                      | $          | 74,637                          |       | $ | 53,122 |   | $ | 52,100 |   | $ | 72,465 |   | $ | 56,391 |   |
| Operating  expenses (3)                                          |   | (62,983                                                                                                                                                                                                                                      | )       | (59,964                                   | )          | (43,142                         | )          | (50,101 | ) | (68,144 | ) | (51,773 | ) |
| Operating  income                                                |   | 19,869                                                                                                                                                                                                                                       |    | 14,673                                    |       | 9,980                           |       | 1,999 |   | 4,321 |   | 4,618 |   |
| Other  income (expense)                                          |   | (6,573                                                                                                                                                                                                                                       | )       | (5,483                                    | )          | (5,550                          | )          | (5,915 | ) | (8,502 | ) | (10,357 | ) |
| Income  (loss) before income taxes                               |   | 13,296                                                                                                                                                                                                                                       |    | 9,190                                     |       | 4,430                           |       | (3,916 | ) | (4,181 | ) | (5,739 | ) |
| Income  tax expense (4)                                          |   | (2,098                                                                                                                                                                                                                                       | )       | (414                                      | )          | —                          |       | — |   | — |   | — |   |
| Net  income (loss)                                               |   | $                                                                                                                                                                                                                                            | 11,198  |                                      | $          | 8,776                           |       | $ | 4,430 |   | $ | (3,916 | ) | $ | (4,181 | ) | $ | (5,739 | ) |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| **PRO FORMA BASIC AND DILUTED EARNINGS PER  SHARE (UNAUDITED):** |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| Net  income (loss)                                               |   |                                                                                                                                                                                                                                         |    |                                      |       | $                               | 3.40       |   |   |   | $ | (3.21 | ) |   |   |
| Pro  forma shares outstanding                                    |   |                                                                                                                                                                                                                                         |    |                                      |       | 1,302,355                       |       |   |   | 1,302,355 |   |   |   |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| **NET INCOME PER COMMON SHARE:**                                 |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| Basic                                                            |   | $                                                                                                                                                                                                                                            | 7.69    |                                      | $          | 6.74                            |       |   |   |   |   |   |   |   |   |
| Diluted                                                          |   | $                                                                                                                                                                                                                                            | 7.41    |                                      | $          | 6.74                            |       |   |   |   |   |   |   |   |   |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| **WEIGHTED AVERAGE NUMBER OF COMMON SHARES  OUTSTANDING:**       |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| Basic                                                            |   | 1,455,443                                                                                                                                                                                                                                    |    | 1,302,355                                 |       |                            |       |   |   |   |   |   |   |
| Diluted                                                          |   | 1,510,741                                                                                                                                                                                                                                    |    | 1,302,355                                 |       |                            |       |   |   |   |   |   |   |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
|                                                             |   | **DECEMBER 31,**                                                                                                                                                                                                                        |    | **YEARS ENDED  MARCH 31,**           |       |
|                                                             |   | **2003**                                                                                                                                                                                                                                     |    | **2002**                                  | ** ** | **2001**                        | ** ** | **2000** | ** ** | **2001** | ** ** | **2000** | ** ** |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       | **(UNAUDITED)** |   |   |   |   |   |
|                                                             |   | **— — — — — — — —  — — — — — — — (Thousands of dollars)— — — — — — — — — — — — — — —** |    |
| **CONSOLIDATED BALANCE SHEET DATA:**                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
|                                                             |   |                                                                                                                                                                                                                                         |    |                                      |       |                            |       |   |   |   |   |   |   |
| Utility  plant, net                                              |   | $                                                                                                                                                                                                                                            | 152,162 |                                      | $          | 156,517                         |       | $ | 164,547 |   | $ | 170,111 |   | $ | 168,920 |   | $ | 169,537 |   |
| Total  assets                                                    |   | 202,989                                                                                                                                                                                                                                      |    | 211,294                                   |       | 214,459                         |       | 218,382 |   | 221,195 |   | 200,881 |   |
| Long-term  debt, net                                             |   | 143,372                                                                                                                                                                                                                                      |    | 148,052                                   |       | 181,732                         |       | 184,688 |   | 188,627 |   | 140,333 |   |
| Equity  and margins                                              |   |                                                                                                                                                                                                                                         |    |                                      |       | 7,672                           |       | 6,012 |   | 5,675 |   | 12,659 |   |
| Stockholders’  equity                                       |   | 26,973                                                                                                                                                                                                                                       |    | 14,738                                    |       |                            |       |   |   |   |   |   |   |
|                                                                  |        |                                                                                                                                                                                                                                              |         |                                           |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

10

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----

| (1) | The Cooperative acquired McCulloch Electric  Cooperative, Inc. effective September 1, 1999. McCulloch’s operations  subsequent to the acquisition are included in the consolidated statements of  operations. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | The Company changed its year-end from  March 31 to December 31, effective December 31, 2001.                                                                                                             |
| (3) | Includes $1,357,000 of impaired costs  related to the Lamar Combination for the year ended December 31,  2002.  See Note 5 to the consolidated  financial statements.                                         |
| (4) | Upon conversion to a shareholder owned  corporation, the activities and transactions of the Company became taxable.                                                                                                     |

 
| **ITEM 7.** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION  AND RESULTS OF OPERATIONS** |
|-------------|-------------------------------------------------------------------------------------------------|

 

**Cautionary StatementRegarding Forward-Looking Statements**

 

Inthe interest of providing shareholders with certain information regarding theCompany’s future plans and operations, certain statements set forth in thisForm 10-K relate to Management’s future plans and objectives.  This Form 10-K contains statements that are“forward-looking statements” under the Private Securities Litigation Reform Actof 1995.  All statements other than statementsof historical facts included in this report, including, without limitation,statements regarding the Company’s future financial position, businessstrategy, budgets, projected costs and plans and objectives of Management forfuture operations, are forward-looking statements.  In addition, forward-looking statements generally can beidentified by the use of forward-looking terminology such as “may,” “will,”“expect,” “intend,” “project,” “estimate,” “anticipate,” “believe,” or“continue” or the negative thereof or similar terminology.  Although any forward-looking statements containedin this Form 10-K or otherwise expressed by or on behalf of the Company are, tothe knowledge and in the judgment of the officers and directors of the Company,believed to be reasonable, there can be no assurances that any of theseexpectations will prove correct or that any of the actions that are plannedwill be taken.  Forward-lookingstatements involve known and unknown risks and uncertainties, which may causethe Company’s actual performance, and financial results in future periods todiffer materially from any projection, estimate or forecasted result.  Important factors that could cause actualresults to differ materially from the Company expectations include, but are notlimited to:

 

•                  Weather conditions;

•                  Change in rate structure and ability to earn afair return on our rate base and recover the costs of operations;

•                  Federal and state regulatory actions, andassociated legal and administrative proceedings, especially as they relate tothe oversight authority of the Public Utility Commission of Texas;

•                  Increased competition in the electric utilityindustry;

•                  Demands for electric power and the associatedcosts, including changes in the costs of power plant fuels such as natural gasand coal;

•                  Changes in the Company’s cash position and availabilityof capital resources;

•                  The impact of changes in interest rates;

•                  Changes in federal and state tax laws;

•                  Unexpected changes in operating expenses andcapital expenditures.

 

Allsubsequent written and oral forward-looking statements attributable to theCompany, or persons acting on its behalf, are expressly qualified in theirentirety by the Cautionary Statements. The Company assumes no duty to update or revise its forward-lookingstatements based on changes in internal estimates or expectations.

 

Thefollowing discussion and analysis of the Company and its Predecessor’sfinancial condition and results of operations for the years endedDecember 31, 2003, 2002 and 2001, and the nine months endedDecember 31, 2001, should be read in conjunction with the Company’saudited consolidated financial statements and

 

11

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relatednotes to financial statements included elsewhere in this document.  Unless otherwise indicated, all referencesto the Company will include any and all activities of its Predecessor.

 

**Overview**

 

CapRock Energy Corporation is an electric distribution company operating invarious non-contiguous areas in the State of Texas. The Company providesservice to over 35,000 meters in 28 counties covering approximately 13,000square miles in Texas. This includes 23,000 meters within two operatingdivisions in the Midland-Stanton area of west Texas, 6,100 meters in thecentral Texas area around Brady, and over 4,200 meters in   northeast Texas in Hunt, Collin and FanninCounties. The Company also provides management services to the FarmersvilleMunicipal Electric System which services nearly 1,500 meters in Farmersville,Texas.

 

TheCompany purchases power from wholesale suppliers and distributes that power toits retail customers over transmission lines covering over 320 miles and thenover 11,000 miles of distribution lines. The Company has not and does not planto engage in the generation of electricity. The Company’s primary focus is onthe distribution of electricity to its customers. In 2003, the Companypurchased all electric power pursuant to wholesale electric power contractswith three suppliers.  Generally, thewholesale electric power supply contracts are based on fixed charges for kWhusage, transportation and auxiliary services and a variable charge for fuelbased on kWh usage. The Company’s purchased power costs fluctuate primarilywith the price of fuel used to generate that electricity, which is primarilynatural gas and coal. However, all costs associated with purchased power arepassed through to the retail customer.

 

EffectiveSeptember 1, 2003, the Company became subject to the oversight authorityof the PUCT, and the rates and fees charged to customers by the Company are nowsubject to PUCT approval.  In accordancewith this change, the Company immediately filed its tariff for electric servicewith the PUCT.  The Company was requiredto submit a standard rate filing package to the PUCT in lateFebruary 2004, in connection with the PUCT’s review of the reasonablenessof the Company’s rates, and its request for a rate increase for some customerclasses.  Because some parties haveintervened in the process, Management believes the proceedings will take alonger period of time, require dedication of more resources and ultimately costthe customer more.  The Company isfocused on being compliant with any rate case proceeding, but is concernedabout the short and long term effects on its resources if the Intervenorsrequests are voluminous and burdensome.

 

In its sustained effortsto divest itself of nonutility assets, the Company reached an agreement withMAP to sell its shares of stock in exchange for a note receivable of $1,250,000due in October 2004.  Although theinvestment appreciated over the period that the Company held it, the salesprice was less than recorded book value, and the Company was required to recorda loss on the sale of $1,056,000.  Uponreceipt of the proceeds from the note receivable, the Company will haverecouped its original cash investment.

 

AtSeptember 30, 2003, the Company had a note payable to a bank for$11,675,000 which was cross-collateralized by notes receivable from United Fueland Energy Corporation (“United Fuel”) in the same amount.  In October 2003, United Fuelconsummated financing with a lender that provided for funds to partially paydown the Company’s note payable to a bank, with United Fuel taking the positionas borrower on the Company’s note payable to a bank, thus extinguishing UnitedFuel’s note receivable to the Company. The Company is no longer a borrower and its involvement has been reducedto being a secondary guarantor for United Fuel’s note of $3,500,000.  FASB Interpretation No. 45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others,” requires the Company to record aguarantee obligation that is measured at fair value.  The Company’s calculation of fair value included factors such asbeing a secondary guarantor and the collateralization of United Fuel’sassets.  The Company has calculated itsexposure and recorded a guarantee obligation of $35,000 inOctober 2003.  Upon United Fuel’srepayment of the note and the bank’s release of the guaranty, scheduled forOctober 2004, the Company will be able to eliminate the recordedobligation.  In March 2004, the Companysigned an agreement with a shareholder of United Fuel to sell its shares ofstock at a sales price of $1,300,000. Consummation of the sale is contingentupon certain future events, such as United Fuel’s capitalizationarrangements.  It is unknown when thoseevents will transpire.

 

12

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TheBoard of Directors adopted a resolution changing the date of the Company’s andthe Cooperative’s fiscal year end from March 31 to December 31,effective for the year ended December 31, 2001.

 

**Critical Accounting Policies and Estimates**

 

TheCompany’s significant accounting policies are described in Note 1 to theconsolidated financial statements. Certain of our accounting policies require the application ofsignificant judgment by Management in selecting the appropriate assumptions forcalculating financial estimates.  Bytheir nature, these judgments and estimates are subject to an inherent degreeof uncertainty.  These judgments andestimates are based on our historical experience, terms of existing contracts,our observance of trends in the industry, information provided by ourcustomers, and information available from other outside sources asappropriate.  Different estimatesreasonably could have been used in the current period, or changes in theaccounting estimates are reasonably likely to occur from period to period, thatcould have a material impact on the presentation of the Company’s financialcondition, changes in financial condition or results of operations.  Management believes that the followingfinancial estimates are both important to the portrayal of the Company’sfinancial condition and results of operations and require subjective or complexjudgments.  Further, it is believed thatthe items discussed below are properly recorded in the financial statements forall periods presented.  Management hasdiscussed the development, selection and disclosure of the most critical financialestimates with the Board of Directors’ Audit Committee.

 

TheCompany’s most critical accounting policy involves rate regulation.  The Company is subject to the provisions ofStatement of Financial Accounting Standards (“SFAS”) Statement No. 71, “Accountingfor the Effects of Certain Types of Regulation.”  In certain circumstances, SFAS No. 71 requires that certain costsand/or obligations be deferred on the balance sheet until matching revenues arerecognized, subject to regulatory approval. It is the Company’s policy to assess the recoverability of costsrecognized as regulatory assets in accordance with SFAS No. 71, based on eachregulatory action and the criteria set forth in SFAS No. 71.  Any disallowance of these deferred costswould be charged against income immediately upon that disallowance.

 

*Power Cost Recovery Factor.*  Thepower cost recovery factor is the difference between the cost of powerpurchased and the cost of power recovered from the customers, divided by thenumber of kilowatt hours billed during the period.  Power purchased includes transmission costs and wheelingcharges.  This factor is estimated eachmonth to recover actual power costs and is added as a surcharge to the baserate.  The factor is based on estimatesof power cost increases/decreases due to changes in fuel cost, usage and othercost fluctuations.  The estimate isadjusted in the subsequent month as compared to actual activity.  The Company currently defers the differencebetween actual purchased cost and billed cost as a regulatory asset orliability.  The regulatory asset orliability, as well as the deferral, are adjusted in the next period by eitherreceipt from, or refund to, the customer the net deferred amount.

 

*Derivative Instruments and HedgingActivities.  *The Company enters into derivativetransactions to manage the cost of natural gas as the fuel component of powercost.  As described in Note 1 to theConsolidated Financial Statements, the pricing under the Company’s variouspower contracts varies with fuel cost, which is generally determined by thecost of natural gas.  These transactionsminimize the fluctuations in their customers’ power bills.  The instruments are measured at fair marketvalue and recorded as an asset or liability with a corresponding regulatoryasset or liability.  Changes in the fairvalue are recognized in current earnings unless specific hedge accountingcriteria are met.  As ofDecember 31, 2003, no derivative portfolio was held.

 

*Revenue Recognition Policy. *For all periods through December 31, 2002, the Company and itspredecessor, the Cooperative, utilized the cycle billing method to recognizerevenue, pursuant to the rate-making policy as set by the Board ofDirectors.  The cycle billing methodrecognizes revenue on an “as billed basis” when the customer is billed and not on an accrual basis, whichrecognized revenue as the power is distributed to the customer.  By utilizing the “as billed” method, unbilledrevenue was not recognized.

 

EffectiveJanuary 1, 2003, the Company’s Board of Directors changed the rate-makingpolicy to recognize unbilled revenue. The Company was then required to change accounting principles related toits revenue recognition method.  Underthe new rate-making structure, the Company recognizes revenue when power isdistributed to the customer, rather than when the customer is billed.

 

13

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*Stock Based Compensation.*  EffectiveJanuary 1, 2003, the Company adopted the fair value method of accountingfor its employee stock incentive plan in accordance with SFAS No. 123,“Accounting for Stock-Based Compensation,” as amended by SFAS No. 148,“Accounting for Stock-Based Compensation, Transition and Disclosure.”  Under the historical or retroactivetransition method allowed by SFAS No. 148, the compensation expense for theyear ended December 31, 2002, would not have been different had the fairvalue method been originally applied.

 

*Tax Liabilities and Valuation ofDeferred Tax Assets. *The Company is required to assess the ultimaterealization of deferred tax assets generated from net operating losses, andcapital losses incurred on the sale of assets. This assessment takes into consideration tax planning strategies withinour control, including assumptions regarding the availability and character offuture taxable income.  AtDecember 31, 2003, we have recorded $8,074,000 of valuation allowancesagainst net deferred tax assets for which the ultimate realization of the taxasset is mainly dependent on the availability of future taxable income andcapital gains.  The ultimate amount ofdeferred tax assets realized could be materially different from that recorded,as impacted by changes in federal income tax laws and upon the generation offuture capital gains to enable us to realize the related tax assets.

 

AtDecember 31, 2003, we also had approximately $7,057,000 of net operatingloss carryforwards that expire in 2008 through 2021, and may be used to offsetfuture taxable income.  We recordedvaluation allowances against the deferred tax assets related to net operatinglosses.  This determination was based onour assessment that it is more likely than not that the Company may not be ableto realize these deferred assets during the carryforward period.  This assessment considered the forecastreversal of existing temporary differences and taxable income expected to begenerated in the carryforward period.

 

*Impairment of Long-livedAssets. *Management reviews the carrying value oflong-lived assets whenever events or changes in circumstances indicate thatsuch carrying values may not be recoverable in accordance with Statement ofFinancial Accounting Standards No. 144, “Accounting for the Impairment orDisposal of Long-lived Assets.” Unforeseen events and changes in conditions could indicate that thesecarrying values may not be recoverable and may therefore result in impairmentcharges.  An impairment loss isrecognized only if the carrying amount of the long-lived asset is not recoverableand exceeds its fair value.  Thecarrying amount of a long-lived asset is not recoverable if it exceeds itsfuture undiscounted cash flows, and if required, fair value of long-lived assetis written down to its fair value.  Thedetermination of future cash flows, and if required, fair value of long-livedasset is by its nature a highly subjective judgment.  Fair value is determined by calculating the discounted futurecash flows using a discount rate, third party contracted bids or appraisalsperformed by a qualified party. Significant judgments and assumptions are required in the forecast offuture operating results used in the preparation of the long-term estimatedcash flows, including long-term forecasts of the amounts and timing of overallmarket growth.  Changes in theseestimates could have a material effect on the assessment of our long-livedassets.

 

*Postretirement HealthcareBenefits. *The Company provides certain postretirementhealthcare benefits to employees and retirees. Determining the costs associated with such benefit is dependent onvarious actuarial assumptions including demographics (age, sex), mortalityrates, discount rates used in determining the projected benefit obligations,and current and projected health care cost trend rates.  Independent actuaries perform the requiredcalculations, in accordance with accounting principles generally accepted inthe United States.  Actual results thatdiffer from the actuarial assumptions are generally accumulated and amortizedover future periods.

 

14

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**Results of Operations**

 
|                      |   | **Year Ended  December 31,**                                                                                                                                            |   | **Nine Months  Ended  December 31,** |   |
|---------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                      |   | **2003**                                                                                                                                                                     |   | **2002**                                  |   | **2001** |   | **2001** |   |
|                      |   | **Successor**                                                                                                                                                                |   | **Successor**                             |   | **Predecessor** |   | **Predecessor** |   |
|                      |   |                                                                                                                                                                         |   |                                      |   | **(Unaudited)** |   |   |   |
|                      |   | **— — — — — — — —  — — — —(Thousands of dollars)— — — — — — — — —** |   |
| **Operating Revenues:**   |   |                                                                                                                                                                         |   |                                      |   |   |   |   |   |
| Electric  Sales           |   | $                                                                                                                                                                            | 81,402 |                                      | $      | 73,335 |   | $ | 72,417 |   | $ | 52,326 |   |
| Other                     |   | 1,450                                                                                                                                                                        |   | 1,302                                     |   | 995 |   | 796 |   |
| Total  operating revenues |   | $                                                                                                                                                                            | 82,852 |                                      | $      | 74,637 |   | $ | 73,412 |   | $ | 53,122 |   |

 

Theconsumption and demand for electricity within the Company’s service areas isgreatly impacted by weather conditions and temperatures.  The hot temperatures during the summermonths, or the third quarter, require residential customers to use more electricityin cooling their homes.  Rural customerswho irrigate crops use more electricity in the summer months for the irrigationprocess, and if the spring season didn’t bring much rain, these customers mayirrigate sooner and longer.  Portions ofthe Company’s service areas have been experiencing a severe long-termdrought.  The National Weather ServiceClimate Prediction Center shows only minimal relief for the ensuing year.

 

Electricrevenues increased $8,067,000 for 2003 as compared to 2002.  This rise is due to multiple factors:

 

•                  Adjustments of $3,060,000 for recovery ofincreased power costs from prior periods were billed to customers;

•                  A regulatory surcharge of $1,539,000 wasbilled to customers, which related to intervention costs;

•                  A change in accounting principle, describedin Note 1 to the consolidated financial statements, from the “as billed” methodto the accrual method, increased electric revenues by $3,400,000;

 

Theregulatory surcharge, authorized by the Company’s Board of Directors, wasintended to recover some of the expense incurred in connection with theCompany’s response to Opposing Intervenors actions, and such surcharge hasconcluded.

 

TheCompany had been realizing deferred revenue of $4,364,000 equally over a 24month period from January 2002 to December 2003.  Although this revenue is recognized equallyin both the 2003 and 2002 periods, it has been fully billed through the powercost recovery factor, and will not be reflected in future periods.  This item related to purchased powerexpensed in prior years, but was recovered from customers over a 24 monthperiod.  This type of item may occur inthe future because of the protocol mandated by FERC for administration of thetransmission tariff.  See also Note 17to the consolidated financial statements. Electric revenues for 2002 were $918,000 greater than those for 2001because of the aforementioned recognition of deferred revenue related torecovery of power cost from prior periods, offset by a decrease in 2002 powercost recovery.

 

Atthe time of the Company’s conversion from an electric cooperative to aninvestor owned electric utility, the Texas Public Utility Regulatory Actprovided that a successor to an electric cooperative, such as the Company,would be treated as a cooperative for regulatory purposes.  This would have allowed the Board ofDirectors of the Company to continue to set the rates that it charges itscustomers.  In September 2001, theCompany and the Cooperative filed an application to transfer the Cooperative’sCertificate of Convenience and Necessity to the Company.  The CCN allows the Cooperative and theCompany to serve electric customers in certain territories within the State ofTexas.  Various Intervenors challenged thistransfer as well as the Company’s right to treatment as a cooperative for regulatorypurposes under the PURA.  Following acontested proceeding, the Pubic Utility Commission of Texas approved thetransfer of the CCN, effective September 1, 2003.

 

However,during the 2003 legislative session, Senate Bill 1280 was adopted by the Texaslegislature which amended the PURA so that the Company would be treated as aninvestor owned utility subject to regulation

 

15

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bythe PUCT.  The Company’s rates are nowsubject to regulation and approval by the PUCT, rather than the Company’s Boardof Directors.  In accordance with thischange in the PURA, the Company filed its electric service tariffs with thePUCT on September 2, 2003.  ThePUCT is currently reviewing those tariffs. In addition, the PUCT initiated an inquiry to determine thereasonableness of the Company’s electric rates and required the Company tosubmit a standard rate filing package. The Company submitted that rate filing package in late February 2004.  The filing contained a request for a rateincrease for the Company’s various customer classes, aggregating approximately14%.  The increase is intended to coverincreased costs of service related to, among other things, property taxes,computer and IT systems, and costs associated with being a regulated investorowned utility.  Several parties haveintervened in these proceedings requesting relief from the PUC.  The major items being sought by the Intervenorsare that the Company’s rates be decreased and that the Company be required torefund all monies it previously collected pursuant to a regulatory surchargeauthorized by the Board of Directors during 2003.  The Company believes its rates are reasonable and that therequested rate increase is appropriate based upon its cost of service andreasonable return on its invested assets. The PUCT has suspended the proposed rate increase pending a formalhearing and the Company’s current rates will remain in effect.  The Company cannot determine what action thePUCT will take with respect to its current rates or its requested rateincrease.  The PURA requires the PUCT torule on the rate request within a specified number of days and the Companyexpects a final ruling in the fourth quarter of 2004.

 

Ifthe Company’s request for a rate increase is approved by the PUCT, the Companymay suffer a decline in consumption by customers.  Because the outcome of the rate request or rate order is unknown,the Company is unable to predict the effect of such order.

 
|                                   |   | **Year Ended  December 31,**                                                                                                                                            |   | **Nine Months  Ended  December 31,** |   |
|----------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                   |   | **2003**                                                                                                                                                                     |   | **2002**                                  |   | **2001** |   | **2001** |   |
|                                   |   | **Successor**                                                                                                                                                                |   | **Successor**                             |   | **Predecessor** |   | **Predecessor** |   |
|                                   |   |                                                                                                                                                                         |   |                                      |   | **(Unaudited)** |   |   |   |
|                                   |   | **— — — — — — — —  — — —(Thousands of dollars)— — — — — — — — — —** |   |
| **Operating Expenses:**                |   |                                                                                                                                                                         |   |                                      |   |   |   |   |   |
| Purchased  power                       |   | $                                                                                                                                                                            | 36,578 |                                      | $      | 36,433 |   | $ | 40,781 |   | $ | 28,194 |   |
| Operations  and maintenance            |   | 10,476                                                                                                                                                                       |   | 7,327                                     |   | 7,427 |   | 5,828 |   |
| General  and administrative            |   | 6,471                                                                                                                                                                        |   | 7,144                                     |   | 4,664 |   | 3,326 |   |
| Depreciation  and amortization         |   | 7,787                                                                                                                                                                        |   | 6,134                                     |   | 6,159 |   | 4,568 |   |
| Property  taxes                        |   | 1,345                                                                                                                                                                        |   | 1,367                                     |   | 1,380 |   | 997 |   |
| Impairment  of Lamar combination costs |   | —                                                                                                                                                                       |   | 1,357                                     |   | — |   | — |   |
| Other                                  |   | 326                                                                                                                                                                          |   | 202                                       |   | 310 |   | 229 |   |
| Total  operating expenses              |   | $                                                                                                                                                                            | 62,983 |                                      | $      | 59,964 |   | $ | 60,721 |   | $ | 43,142 |   |

 

Purchasedpower expense normally moves in relation to electric demand and consumption.  Contract terms with wholesale power suppliersprovide for pricing based upon the price of fuel, demand and usage.  All costs of power are passed through to theCompany’s retail customers.  Purchasedpower only increased $145,000 from 2002 to 2003.  The net change is attributable to:

 

•                  The change in accounting principle forunbilled revenues in 2003, described in Note 1 to the consolidated financialstatements, caused a catch up in the purchased power cost lag of $1,318,000;

•                  An increase of $1,896,000  in power costs offset by a decrease in netconsumption;

•                  A decrease in wheeling charges of $250,000;

•                  A conclusion in September 2003 to therate making treatment of the capital lease payments which were associated withthe transmission system.  This caused adecrease of $2,773,000.

 

Thecost of natural gas has risen from 2002 to 2003, which has increased the costof purchased power and is passed directly through to customers.  Management expects natural gas prices toremain flat for 2004.

 

16

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Certainservice areas of the Company have experienced a rise in consumption, whereasother service areas reflect a decline in consumption.  The weather in the Company’s service area for 2003 as compared to2002 has been milder:  the winter hasbeen less severe, and the summer months didn’t experience as many days over 100degrees.

 

Purchasedpower cost decreased by $4,348,000 in 2002 due to high natural gas prices andfixed price contract losses during the early months of 2001.  Natural gas prices affect the cost of powergeneration, which is passed through from our power suppliers.  Taking the aforementioned changes in 2001into account, the nine month period ended December 31, 2001, wascomparable in nature to 2002.

 

Asmentioned above, the rate making treatment of the transmission system capitallease payments concluded in September 2003, as a result of final paymenton the capital lease.  Rate makingtreatment required the Company to classify the amortization of property andequipment under the capital lease, as well as the associated interest expense,as purchased power.  Total amountsincluded in purchased power which are associated with the capital lease are$4,403,000, $6,490,000, $6,502,000 and $4,882,000 for 2003, 2002, 2001, and thenine months period ended December 31, 2001, respectively.  Because the capital lease has beenextinguished, this treatment is no longer applicable, and future periods willnot reflect this expense.  The remainingnet book value of the transmission system will be depreciated over itsremaining life, and will be reflected in Depreciation and Amortization expense.

 

Factorsaffecting operations and maintenance expense are certain weather conditionssuch as high winds, ice storms and lightning which cause damage to electriclines and interrupt service.  Operationsand maintenance increased $3,148,000 between 2002 and 2003.  The majority of the change is related to anincreased need in maintenance for the distribution and transmission systems whichresulted in current expense, as opposed to engaging in construction activitiesthat would have resulted in capitalized costs.

 

InApril 2003, each employee was granted a noncash stock award, with vestingover 5 years.  Officers, directors andcertain retired directors were also granted noncash stock awards inJuly 2003, with vesting periods ranging from 2 to 5 years.  The expense associated with these noncashawards is being amortized to expense over periods of 2 to 5 years.  This expense was allocated betweenOperations and Maintenance expense, and General and Administrative expense,based upon the respective employee’s or officer’s function within theCompany.  For 2003, the allocation ofnoncash compensation of $2,021,000 was $340,000 to Operations and Maintenance,and $1,681,000 to General and Administrative. Expected noncash compensation expense by year is as follows: 2004 -$2,317,000, 2005 - $760,000, 2006 - $325,000, 2007 - $316,000 and 2008 -$105,000.

 

Generaland administrative expenses decreased by $673,000 between 2002 and 2003.  The aforementioned noncash stock awards of$1,681,000 for 2003 were offset by decreases in legal and professional fees,the majority of which were associated with the PUCT proceedings concerning theapplication to transfer the Cooperative’s certified territory to the Company,as well as decreases in public reporting costs.

 

Theincrease of $2,480,000 in general and administrative expense from 2001 to 2002was primarily due to legal expenses associated with PUCT hearings, discussedpreviously, and shareholder related costs.

 

TheCompany expects general and administrative expenses to increase in the futurebecause compliance with PUCT rules and regulations, as well as the SarbanesOxley Act of 2002, will require more personnel.

 

Depreciationand amortization increased $1,653,000 from the year ended 2002 as compared to2003 for various reasons:

 

•                  Amortization of the fees and costs associatedwith the original transmission system capital lease were escalated by $544,000,in order that these costs would be fully amortized by the end of the leaseterm;

•                  Increased depreciation expense of $359,000associated with changes in estimated useful lives of certain general plantassets;

•                  Initial amortization of $333,000 of the legalfees and costs incurred with respect to consummation of the Beal Bank loan;

 

17

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•                  Conclusion of the rate making treatment ofthe amortization of property and equipment associated with the transmissionsystem capital lease caused an increase of $220,000.

 

Inconnection with the original ten year capital lease associated with thetransmission system, generally accepted accounting principles required theCompany to amortize the asset over a period consistent with the leasepayments.  This period was much shorterthan the estimated life of the asset, and the amortization was charged topurchased power.  Because the capitallease was extinguished in September 2003, and the rate-making treatment isno longer applicable, the method of depreciation and life of the transmissionsystem assets has changed to a straight-line method with a 20 year remaininglife, and the expense is reflected in Depreciation and Amortizationexpense.  The Company estimates theamount of such depreciation on the transmission system to be $864,000 per year.

 

Inits efforts to be able to adapt to a changing regulatory environment, enhanceefficiency, automate certain processes, position itself to pursue potentialacquisitions and increase its customer base, management recognized the need fora more sophisticated and responsive IT system and associated applications.  The Company engaged an objective outsidethird party to assess the Company’s current and future IT needs, assist in theselection process of software and related applications, implement the chosenproducts and processes and provide ongoing support.  The third party IT company is also assisting the Company inproviding IT internal control documentation and procedures in order that theCompany may begin the process of compliance with the Sarbanes Oxley Act of2002.

 

CertainIT costs associated with the change in the operating environment, theapplications and implementation process have been capitalized.  These costs, which aggregate $3,881,000 atDecember 31, 2003, will be amortized over 5 years beginningMarch 2004.  In addition, theongoing costs for maintenance and IT support is based on the number of metersand will approximate $1,697,000 per year through the term of the contract whichis December 2007.  All applicationsare anticipated to be operational by the end of 2004.

 

Althoughproperty tax expense has remained relatively constant for the past few years,the Company anticipates property tax expense for 2004 will materially increasedue to current appraisal methodologies used in the ad valorem taxation ofinvestor owned utilities in Texas. Estimates of the Company’s revenue-generating ability are alsoconsidered in the appraisal process. The Company has increased its projection for property tax expense for2004 from $1,345,000 to $3,000,000.

 

Asdescribed more fully in Note 23 to the consolidated financial statements, in1999 the Company entered into an agreement to combine with Lamar ElectricCooperative (“Lamar”).  Lamar terminatedthe agreement in late 2002.  Althoughthe Company is seeking to recover the costs and expenses incurred in connectionwith the combination, generally accepted accounting principles required theimpairment of those capitalized costs, which aggregated $1,357,000.

 
|                                                |   | **Year Ended  December 31,**                                                                                                                                            |   | **Nine Months  Ended  December 31,** |   |
|-----------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                |   | **2003**                                                                                                                                                                     |   | **2002**                                  |   | **2001** |   | **2001** |   |
|                                                |   | **Successor**                                                                                                                                                                |   | **Successor**                             |   | **Predecessor** |   | **Predecessor** |   |
|                                                |   |                                                                                                                                                                         |   |                                      |   | **(Unaudited)** |   |   |   |
|                                                |   | **— — — — — — — —  — — —(Thousands of dollars)— — — — — — — — — —** |   |
| **Other Income (Expense):**                         |   |                                                                                                                                                                         |   |                                      |   |   |   |   |   |
| Allocation  of income from associated organizations |   | $                                                                                                                                                                            | 530    |                                      | $      | 478 |   | $ | 1,290 |   | $ | 1,205 |   |
| Interest  expense, net of capitalized interest      |   | (6,979                                                                                                                                                                       | )      | (7,103                                    | )      | (10,818 | ) | (8,004 | ) |
| Interest  and other income                          |   | 788                                                                                                                                                                          |   | 1,027                                     |   | 1,582 |   | 1,161 |   |
| Loss  on sale of MAP stock                          |   | (1,056                                                                                                                                                                       | )      | —                                    |   | — |   | — |   |
| Equity  earnings in MAP                             |   | 144                                                                                                                                                                          |   | 115                                       |   | 89 |   | 88 |   |
| Total  other income (expense)                       |   | $                                                                                                                                                                            | (6,573 | )                                         | $      | (5,483 | ) | $ | (7,857 | ) | $ | (5,550 | ) |

 

18

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Althoughinterest expense only decreased $124,000 from 2002 to 2003, the majorcomponents changed.  Because the Companywas able to lock in at some lower interest rates, coupled with a decliningprincipal balance, interest expense on mortgage debt was reduced by$535,000.  The cross-collateralized notepayable to a bank had a declining balance and was extinguished inSeptember 2003.  This was a changeof $186,000 between 2002 and 2003.  Thedraw on the initial advance in September 2003 from Beal Bank of 10.75% perannum caused an increase of $478,000.

 

Interestexpense decreased by $3,715,000 in 2002 from 2001 due to a decline in variableinterest rates.  Long-term variablerates were 3.4% in December 2002 compared to 4.7% in December 2001.  The rates on the $28,000,000 line of creditwere 3.65% and 5.1% for December 2002 and December 2001,respectively.

 
|                    |   | **Year Ended  December 31,**                                                                                                                                            |   | **Nine Months  Ended  December 31,** |   |
|-------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                    |   | **2003**                                                                                                                                                                     |   | **2002**                                  |   | **2001** |   | **2001** |   |
|                    |   | **Successor**                                                                                                                                                                |   | **Successor**                             |   | **Predecessor** |   | **Predecessor** |   |
|                    |   |                                                                                                                                                                         |   |                                      |   | **(Unaudited)** |   |   |   |
|                    |   | **— — — — — — — —  — —(Thousands of dollars)— — — — — — — — — — —** |   |
| **Income Tax Expense:** |   |                                                                                                                                                                         |   |                                      |   |   |   |   |   |
| Income  tax expense     |   | $                                                                                                                                                                            | 2,098  |                                      | $      | 414 |   | — |   | — |   |
|                         |        |                                                                                                                                                                              |        |                                           |        |  |  |  |  |  |  |

 

Forthe year and nine months ended December 31, 2001, the Company incurred nocurrent income tax expense because it was able to utilize net operating losscarryforwards.  Income tax expenseincreased $414,000 in 2002 and $1,684,000 in 2003.  As of December 31, 2003, the Company has net operating losscarryforwards of approximately $19.1 million, which are scheduled to expire in2008 through 2021.  The Company hasbenefited approximately $5 million of net operating loss carryforwards becauseit has tax planning strategies available to realize the benefit of its tax losscarryforwards.

 

TheIRS has notified the Company that it intends to examine the federal income taxreturn of the Cooperative for the year 2001. Because the Cooperative is a nontaxable entity, and the Company feels itfiled a proper return, management believes that the outcome of the audit willnot have a material effect on the Company’s financial position, results ofoperations or liquidity.

 

**ContractualObligations and Other Commitments**

 

Thefollowing table summarizes the Company’s obligations and commitments to makefuture payments under certain contractual obligations:

 
|                             |   | **2004**                                                                                                                                                                                                                             |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   | **Total** |   |   |
|----------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|-----------|--------|--------|
|                             |   | **— — — — — — — —  — — — — — — — — —(Thousands of dollars)— — — — — — — — — — — —** |   |
|                             |   |                                                                                                                                                                                                                                 |   |
| Debt  obligations                |   | $                                                                                                                                                                                                                                    | 18,700 |     | $      | 8,330    |   | $        | 4,586  |     | $      | 4,721          |   | $         | 28,430 |   | $ | 97,121 |   | $ | 147,719 |   |   |
| Capital  lease obligations       |   | 123                                                                                                                                                                                                                                  |   | 110      |   | 57       |   | 18       |   | —   |   | —         |   | 308       |   |   |
| Operating  lease obligations     |   | 314                                                                                                                                                                                                                                  |   | 97       |   | 79       |   | 42       |   | 27       |   | 25             |   | 584       |   |   |
| Purchase  obligations (1)        |   | 2,314                                                                                                                                                                                                                                |   | 1,837    |   | 1,837    |   | 1,837    |   | 140      |   | 811            |   | 8,776     |   |   |
| Other  long term liabilities (2) |   | 1,188                                                                                                                                                                                                                                |   | 1,253    |   | 641      |   | 659      |   | 622      |   | 3,128          |   | 7,491     |   |   |
|                             |   |                                                                                                                                                                                                                                 |   |     |   |     |   |     |   |     |   |           |   |      |   |   |
| **Total**                        |   |                                                                                                                                                                                                                                 |   |     |   |     |   |     |   |     |   |           |   |      |   |   |
|                                  |        |                                                                                                                                                                                                                                      |        |          |        |          |        |          |        |          |        |                |        |           |        |        |  |  |  |  |  |  |  |

 

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(1)          All ofthe Company’s power contracts are firm, full requirements contracts.  These types of contracts require the Companyto purchase all of its power needs from the seller, but do not mandate aminimum purchase amount.  Therefore,amounts included for each year are basic required transmission charges.  Also included are commitments for ITservices.

(2)          Includesactuarially calculated amounts for post retirement healthcare costs of $605,000  $684,000 $709,000  $747,000 and  $743,000 for the years 2004, 2005, 2006,2007, and 2008, respectively, as well as $3,103,000 for 2009 through 2013.  Also the Company has a contract with theCity of Farmersville, Texas, to provide power and assume related billing andcollections functions.  The Company isobligated to

 

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the City to make payments on arevenue sharing type basis.  The 2004,and estimated 2005, annual payments are $626,000.

 

**Liquidity and Capital Resources**

 

Asof December 31, 2003, the Company had:

 

•                  Cashand cash equivalents of $12,170,000;

•                  Currentrestricted cash investment of $14,169,000;

•                  Workingcapital of $9,080,000; and

•                  Long-termindebtedness of $143,372,000, net of current portion.

 

TheCompany requires capital to fund utility plant additions, working capital andother utility expenditures which are recovered in subsequent and future periodsthrough rates.  Capital necessary tomeet these cash requirements is now derived primarily from internally generatedfunds.

 

Through2001, one of the Company’s primary sources of capital and liquidity had beenborrowings from CFC, the Company’s primary lender. These borrowings arecollateralized by substantially all of the Company’s utility distributionassets. The existing long-term debt consists of a series of loans from CFC thatimpose various restrictive covenants, including the prohibition of additionalsecured indebtedness, or the guaranty of such, and requires the maintenance ofa debt service coverage ratio as defined in the CFC loan agreements. Inaddition, the Company may not make any cash distribution or any generalcancellation or abatement of charges for electric energy or services to itscustomers if the ratio of equity to total assets is less than a statedpercentage. At December 31, 2002, the Company was in compliance with itsCFC loan agreements or had obtained waivers of certain covenants therein thatthe Company was required to meet.

 

InDecember 2002, the Company elected to convert the interest rates on themajority of the mortgage notes from variable to fixed.  These lock-ins of interest rates were donefor one, two and three year periods. Substantially all of the CFC fixed rate notes are subject to interestrate repricing at the end of various periods, at the Company’s option.

 

| **Interest  rate**   |   | **Repricing  January** |   | **Amount** |        |
|----------------------|--------|------------------------|--------|------------|-------------|
| Fixed                | 3.35%  |                   |   | 2004       |        | $ | 10,400,000 |   |
| Fixed                | 4.20%  |                   |   | 2005       |        | 69,109,000 |   |
| Fixed                | 4.70%  |                   |   | 2006       |        | 34,128,000 |   |
| Fixed                | 4.50%  |                   |   | 2007       |        | 6,080,000 |   |
| Fixed                | 4.30%  |                   |   | —     |        | 28,000,000 |   |
| Fixed                | 7.00%  |                   |   | —     |        | 2,000 |   |
|                 |   |                   |   |       |        |
| Total long term debt |   |                   |   | $          | 147,719,000 |   |

 

NewCorpsubmitted an application to the Federal Energy Regulatory Commission inJuly 2003, seeking authorization to borrow $31,500,000 from Beal Bank S.S.B.(“Beal Bank”).  FERC approval wasreceived in August 2003.  Thearrangement with Beal Bank was segregated into two advances.  The initial advance provided proceeds of$14,076,000 for payment of the balloon payment on the transmission systemcapital lease, plus interest of $93,000 for a total of $14,169,000. Theadditional advance of $17,331,000 provides for $5,500,000 for working capitaland cash reserves for operations and maintenance of the transmission system,purchase of transmission assets from Cap Rock Energy Corporation, repayment ofa loan to another subsidiary, as well as payment of all costs and expensesassociated with the new loan arrangement. The new financing would also allow NewCorp to make such system upgrades,improvements and expansions, as may be necessary.

 

The initial advance of$14,169,000 was completed in September 2003.  Simultaneously, the original lien on the transmission system wasreleased and the sinking fund of $8,207,000 was transferred to a restricted securitiesaccount.  NewCorp added $5,962,000 tothe restricted securities account to bring the total restricted cash

 

20

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investment to$14,169,000, the amount of the initial advance proceeds.  This restricted cash investment is the onlyasset collateralized by Beal Bank in connection with the initial advance.  Upon funding of the additional advance, therestricted cash investment would be released, and the transmission system,receivables and other assets related to the transmission system would becollateral for the full loan.

 

Intereston the Beal Bank loan is the greater of 10.75% per annum, or 7% plus theone-month LIBOR rate, payable monthly. The initial advance amount of $14,169,000 is due September 9, 2004,unless the additional advance is funded on or before that date, in which case,the entire principal amount would be payable monthly amortized over 15years.  Pursuant to the terms of thefinancing arrangement, prepayment of the initial advance is not allowed beforeits scheduled maturity date; prepayment of the additional advance would not beallowed for the first 24 months of the loan period, with a 1% fee if prepaymentwas made during months 25 through 48. The financing arrangement also provided for a commitment fee of 2% ofthe total loan amount with $457,000 payable for the initial advance, and theremaining $173,000 payable for the additional advance.  Additional customary fees payable to BealBank were for reimbursement of expenses, attorney fees, appraisals and consulting.  Total fees and costs incurred in connectionwith the Beal Bank advance through December 31, 2003, aggregated$999,000.  Maintenance of certainfinancial covenants would be required upon funding of the additional advance,and the Company and NewCorp are already in compliance with such futurerequirements.  The Company would berequired to maintain consolidated net worth of $5,000,000 and NewCorp would berequired to maintain a ratio of net income plus interest, taxes, depreciationand amortization to debt service of at least 1.2 on a rolling quarter basis.

 

Inthe accompanying consolidated balance sheet at December 31, 2003, theinitial advance of $14,169,000 is shown in current liabilities because it isnot certain that the Company will draw on the additional advance from BealBank.  The Company has other availableoptions, which it may pursue, such as refinancing the debt with another lender,entering into a sale leaseback arrangement or selling the transmissionsystem.  All of the options available tothe Company are contingent upon the transfer of NewCorp’s CCN.  See Note 23, “Commitments andContingencies,” to the consolidated financial statements. Whether the Companydraws on the additional advance with Beal Bank or another option is chosen, therestricted cash investment will be released at the same time.  If the Company draws on the additionaladvance, the restricted cash investment of $14,169,000 would be released andavailable for use in operations, as well as new capital of $17,331,000.  If the Company pursues one of the otheroptions, the restricted cash investment would be used to satisfy the initialadvance of $14,169,000, shown in the table for 2004 under “ContractualObligations and Other Commitments.”

 

Whenthe regulatory process has been completed and the PUCT issues a final orderconcerning retail rates, the Company may consider having a secondary commonstock offering.  The offering couldinclude the issuance of three to five million shares and would be used toreduce debt.  This would bring the debtto equity ratio to 60/40, which management believes is more in line withcomparable electric utilities.  At thattime, the Company would also consider implementing a dividend policy.

 

Oneof the options offered to the Cooperative’s members in connection with theCompany’s conversion from a cooperative to a shareholder owned corporation, wasto receive their patronage capital in the form of credits on their utilitybills ratably over a 24 month period. These credits were shown as liabilities on the consolidated balancesheets at December 31, 2002 and 2001. The 24 month period ended November 2003.  Therefore, cash generated from customer payments of utilitybillings should increase by approximately $325,000 per year.

 

Althoughthe outcome concerning the PUCT’s final order on the Company’s retail rates areunknown, with the current working capital position and the availability ofother capital, Management feels the Company has adequate resources to meet itsobligations for 2004, including those enumerated in the table under“Contractual Obligations and Other Commitments.”

 

**New Accounting Standards**

 

**EffectiveJanuary 1, 2003, the Company adopted SFAS No. 143, “Asset RetirementObligations,” which addresses the financial accounting and reporting forobligations associated with the retirement of tangible**

 

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**long-lived assets andthe associated asset retirement costs. The implementation of this standard did not have a material impact onthe Company’s financial position or results of operations.**

** **

**SFAS No. 146,“Accounting for Costs Associated with Exit or Disposal Activities,” requiresthat a liability for costs associated with an exit or disposal activity berecognized and measured initially at fair value only when the liability isincurred.  SFAS No. 146 is effective forexit or disposal activities that are initiated after December 31, 2002,and was adopted by the Company effective January 1, 2003.  The implementation of this standard did nothave an impact on the Company’s financial position or results of operations.**

** **

**In November 2002, the FASB issued FASB InterpretationNo. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, including Indirect Guarantees of Indebtedness of Others” (“FIN45”). FIN 45 requires a guarantor to recognize a liability, at the inception ofthe guarantee, for the fair value of obligations it has undertaken in issuingthe guarantee and also include more detailed disclosures with respect toguarantees. FIN 45 is effective for guarantees issued or modified afterDecember 31, 2002 and requires the additional disclosures for interim orannual periods ended after December 15, 2002.  See Note 14 to the consolidated financial statements concerningthe Company’s guarantee of debt of United Fuel.**

** **

**In January 2003, the FASB issued FASB InterpretationNo. 46, “Consolidation of Variable Interest Entities — an interpretation of ARBNo. 51” (“FIN 46”).  An additionalinterpretation, Interpretation No. 46R, was issued by the FASB inDecember 2003.  FIN 46 and 46Rrequire that if an entity has a controlling financial interest in a variableinterest entity, the assets, liabilities and results of activities of thevariable interest entity should be included in the consolidated financialstatements of the entity. FIN 46 requires that its provisions are effectiveimmediately for all arrangements entered into after January 31, 2003. Forthose arrangements entered into prior to January 31, 2003, the FIN 46provisions are required to be adopted at the beginning of the first interim orannual period beginning after June 15, 2003. The Company owns no interestsin variable interest entities, and therefore neither of these interpretationshas affected the Company’s consolidated financial statements.**

** **

**In December, 2002, the FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation, Transition and Disclosure,” (SFAS No.148) an amendment of FASB Statement No. 123. SFAS No. 148 amends FASB Statement No. 123, “Accounting for Stock-BasedCompensation” (SFAS No. 123), to provide alternative methods of transition fora voluntary change to the fair value based method of accounting for stock-basedemployee compensation.  In addition,SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method used on reported results. Effective January 1, 2003, the Company changed its method ofaccounting from the intrinsic method per APB Opinion No. 25, to the fair valuemethod per SFAS No. 148, and the impact of such change is not material.**

** **

**On April 22, 2003, the FASB announced its decision torequire all companies to expense the fair value of employee stock options.  Companies will be required to measure thecost according to the fair value of the options.  Although the new guidelines and ultimate measurement valuationmethodology have not yet been released, it is expected that they will befinalized soon and effective in 2004. When final rules are announced, the Company will assess the impact toits financial statements.**

** **

**In April 2003, the FASB issued Statement No. 149(“SFAS No. 149”), “Amendment of Statement 133 on Derivative Instruments andHedging Activities.”  SFAS No. 149amends and clarifies financial accounting and reporting requirements forderivative instruments, including derivative instruments embedded in othercontracts, and for hedging activities under FASB Statement No. 133, “Accountingfor Derivative Instruments and Hedging Activities.”  In general, SFAS No. 149 is effective for contracts entered intoor modified after June 30, 2003, and for hedging relationships designatedafter June 30, 2003.  Adoption ofthis statement did not have a material impact on the Company’s financialposition or results of operations.**

** **

**In May 2003, the FASB issued Statement No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity” (“SFAS No. 150”).  Thisstatement establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity.  This statement is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is**

 

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**effective at the beginning of the first interim periodbeginning after June 15, 2003. Adoption of SFAS No. 150 did not have a material impact on its financialstatements.**

** **

**ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Marketrisk represents the risk of changes in the value of a financial instrumentcaused by fluctuations in interest rates, foreign currency exchange rates,prices of commodities and equity price risks.

 

**Commodity Price Risk**

 

Allpurchases of electricity are pursuant to long-term wholesale electric powercontracts based on a fixed price for kWh usage, transportation and auxiliaryservices, with a variable charge for fuel cost, which is generally natural gas.This variable cost is affected by unpredictable factors, including weather andworldwide events, which in turn impact supply and demand.  The Company’s exposure to purchased powerprice risk is substantially mitigated because all actual costs of power areable to be recovered from billings to customers.

 

**Credit Risk**

 

TheCompany’s concentrations of credit risk consist primarily of cash, tradeaccounts receivable, sales concentrations with certain customers, a guaranteeof third party debt and notes receivable from third parties.

 

Creditrisk with financial institutions is considered minimal because of the numberand various physical locations of different financial institutionsutilized.  In the past, the Company hasutilized repurchase agreements, and may consider using that vehicle again inthe future to maximize return and minimize credit risk.

 

TheBeal Bank loan documents related to the restricted cash investment of$14,169,000 at December 31, 2003, provide that the collateral may only beinvested in US government securities, bank certificates of deposit, moneymarket funds or other approved investments with varying terms of one year orless.  Whether the Company draws on theadditional advance with Beal Bank, or another option is chosen, this restrictedcash investment will be released at the same time.

 

TheCompany conducts credit evaluations of new customers and assesses the need fora deposit by that customer.  The depositamount is normally set as 1/6 of an annual customer billing, with such amountsbeing refunded or credited to the customer after one year if the customer haspaid timely at least 10 of the previous 12 billings.  No customer accounted for 10% or more of the operating revenuesof the Company.

 

TheCompany had a note payable to a bank which was cross-collateralized by notesreceivable from United Fuel and Energy Corporation in the same amount, which atSeptember 30, 2003, were $11,675,000. In October 2003, United Fuel consummated financing with a lenderthat provided for funds to partially pay down the Company’s note payable to abank, with United Fuel taking the position as borrower on the Company’s notepayable to a bank, thus extinguishing United Fuel’s note receivable to theCompany.  The Company is no longer aborrower and its involvement has been reduced to being a secondary guarantorfor United Fuel’s note of $3,500,000. FASB Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers,” requires the Company to record a guarantee obligation that is measuredat fair value.  The Company’scalculation of fair value included factors such as being a secondary guarantorand United Fuel’s assets collateralizing the note.  The Company has calculated its exposure and recorded a guaranteeobligation of $35,000.  Upon UnitedFuel’s repayment of the note and the bank’s release of the guaranty, scheduledfor October 2004, the Company will be able to eliminate the recorded obligation.

 

TheCompany sold its investment in MAP effective October 2003, in exchange fora note receivable of $1,250,000 due October 2004.  The note receivable is collateralized by theoriginal stock.  The Company also soldits investments in real estate partnerships in February 2004, in exchangefor a note receivable of $286,000 due 2009. There was no gain or loss on the sale. The note is collateralized by thepartnership interests.  AtDecember 31, 2003, the Company had guaranteed an aggregate of $5,178,000of debt of some of these partnerships. The sale of the partnership interests also involved the transfer ofthose guarantees to the buyer.

 

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**Interest Rate Risk**

 

Weare subject to market risk associated with interest rates on our CFC long-termindebtedness.  The Company’s mortgagedebt with CFC allows for a change from variable rate to fixed rate with noadditional fees.  Mortgage notes of$69,109,000 with current interest rates of 4.2% are due to be repriced inJanuary 2005, mortgage notes of $34,128,000 with current interest rates of4.70% are due to be repriced in January 2006, $3,632,000 of mortgage noteswere repriced in January 2004 with a variable interest rate of 2.9% and$6,767,000 of mortgage notes were repriced in January 2004 with aninterest rate of 3.05%, to be repriced again in January 2005.  The former line of credit of $28,000,000 hasa fixed rate of 4.3%.  Although all ofthe Company’s debt is currently at fixed rates, a 1% change in interest rateswould cause a change of $1,619,000 in interest expense.  The Company attempts to take advantage oflow interest rate environments, as well as repricing interest rates overstaggered periods.

 

Changesin market interest rates affect the interest earnings on the restricted cashinvestment which, at December 31, 2003, had a balance of $14,169,000.  The terms of the Beal Bank loan documentsprovide that the collateral may only be invested in US government securities,bank certificates of deposit, money market funds or other approved investments,with varying terms of one year or less. The weighted average interest rate for the investments for the fourmonths ended December 31, 2003, the period that the investments were held,was less than one percent.

 
| **ITEM 8.** | **FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA** |
|-------------|-------------------------------------------------|

 

TheConsolidated Financial Statements are set forth on pages F-1 through F-39 ofthis Form 10-K.

 
| **ITEM 9.** | **CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING  AND FINANCIAL DISCLOSURE** |
|-------------|-------------------------------------------------------------------------------------------|

 

None

 
| **ITEM 9(a).** | **CONTROLS AND PROCEDURES** |
|----------------|-----------------------------|

 

Asof the end of the period covered by this report, an evaluation was performedunder the supervision and with the participation of the Company’s management,including the Chief Executive Officer and the Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures pursuant to Exchange Act Rule 13a-15.  Based on that evaluation, the Chief Executive Officer and theChief Financial Officer concluded that the design and operation of thesedisclosure controls and procedures were effective.  There have been no changes in the Company’s internal controlsover financial reporting identified in connection with the evaluation referredto above that materially affected, or are reasonably likely to materiallyaffect, the Company’s internal controls over financial report.

 

24

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**PART III**

 

**ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

**Directors And Executive Officers**

 

The information relating toour directors required by Item 10 is set forth in our definitive proxystatement to be filed with the SEC for our 2004 Annual Meeting of Shareholdersto be held on June 15, 2004.  Suchinformation is incorporated herein by reference to the material appearing underthe captions “Election of Directors” and “Section 16(a) BeneficialOwnership Reporting Compliance” in the proxy statement to be filed by us withthe SEC.

 

The information required bythis item concerning the Company’s executive officers is included in Part I,Item 4, of this Form 10-K.

 

**ITEM 11. EXECUTIVE COMPENSATION**

 

The information requiredby Item 11 will be set forth in our definitive proxy statement to be filed withthe SEC for our 2004 Annual Meeting of Shareholders to be held on June 15,2004.  Such information is incorporatedherein by reference to the material appearing under the captions “Compensationof Directors,”  “Compensation of NamedExecutive Officers,”  “PerformanceGraph” and “Compensation Committee Report” in the proxy statement to be filedby us with the SEC.

 

**ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT**

 

The information required byItem 12 will be set forth in our definitive proxy statement to be filed withthe SEC for our 2004 Annual Meeting of Shareholders to be held on June 15,2004.  Such information is incorporatedherein by reference to the material appearing under the caption “BeneficialOwnership of Voting Securities” and “Equity Compensation Plans” in the proxystatement to be filed by us with the SEC.

 

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

Theinformation required by Item 13 will be set forth in our definitive proxystatement to be filed with the SEC for our 2004 Annual Meeting of Shareholdersto be held on June 15, 2004.  Suchinformation is incorporated herein by reference to the material appearing underthe caption “Certain Relationships and Related Transactions” in the proxystatement to be filed by us with the SEC.

 

**ITEM 14.  PRINCIPAL ACCOUNTANTFEES AND SERVICES**

 

Informationcalled for by Part III, Item 14, is included in our proxy statement relating toour annual meeting of shareholders to be held on June 15, 2004, and isincorporated herein by reference.

 

25

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**PART IV**

 

**ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTSON FORM 8K**

 

**Financial Statements**

 

Fora list of the consolidated financial statements filed as part of this Form10-K, see the Index to Consolidated Financial Statements on page F-1.

 

**Financial Statement Schedule**

 

Thefollowing financial statement schedules are included in Item 14:Schedule II - Valuation and Qualifying Accounts for the years endedDecember 31, 2003 and 2002, and the nine months ended December 31, 2001.

 

**Reports on Form 8-K**

 

Thefollowing reports on Form 8-K were filed either during the three months endedDecember 31, 2003, or between December 31, 2003, and the date of thisreport;

 

1.                                       October 14, 2003, Item 5.  Other Events.  Re:  Sale of MAP Stock,extinguishment of note payable to bank and note receivable from United Fuel,and new guaranty on United Fuel debt.

2.                                       November 14, 2003, Item 7 and 12.  Re: Disclosure of financial results for the quarter ended September 30,2003.

3.                                       February 26, 2004, Item 5.  Other Events.  Re:  Filing of rate casewith Public Utility Commission of Texas.

 

26

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**Exhibits**

 
| **Exhibit No.** |   | **Item**                                                                                                                                                                                                                                                                                                                   |
|-----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit  3.1    |   | Articles  of Incorporation of the Company and amendments thereto (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                                                                                                     |
| Exhibit  3.2    |   | Bylaws  of the Company (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01) (1)                                                                                                                                                                                                                              |
| Exhibit  3.2a   |   | Amended  and Restated Bylaws of Cap Rock Energy Corporation(2)                                                                                                                                                                                                                                                             |
| Exhibit  3.3    |   | Restated  and Amended Articles of Incorporation of the Cooperative (originally filed  with Amendment No. 1 to Form S-1 dated 3/20/01) (1)                                                                                                                                                                                  |
| Exhibit  3.4    |   | Bylaws  of the Cooperative (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01)(1)                                                                                                                                                                                                                           |
| Exhibit  3.5    |   | Amended  and Restated Bylaws of the Company (originally filed with Amendment No. 4 to  Form S-1 dated 6/17/01) (1)                                                                                                                                                                                                         |
| Exhibit  3.6    |   | Amended  and Restated Articles of Incorporation of the Company (originally filed with  Amendment No. 4 to Form S-1 dated 6/17/01) (1)                                                                                                                                                                                      |
| Exhibit  3.7    |   | Articles  of Amendment to the Amended and Restated Articles of Incorporation of the  Company (originally filed with Amendment No. 4 to Form S-1 dated 6/17/01) (1)                                                                                                                                                         |
| Exhibit  3.8    |   | Amended  and Restated Bylaws of the Company(1)                                                                                                                                                                                                                                                                             |
| Exhibit  5.1    |   | Opinion  of Ronald W. Lyon (original filed with Amendment No. 3 to Form S-1 dated  5/11/01)(1)                                                                                                                                                                                                                             |
| Exhibit  8.1    |   | Tax  Opinion of Looper Reed & McGraw, a Professional Corporation (originally  filed with Amendment No. 2 to Form S-1 dated 4/25/01) (1)                                                                                                                                                                                |
| Exhibit  10.1   |   | Second  Amendment to Transaction Documents dated November 9, 1994, between  Southwestern Public Service Company, the Cooperative, et. al. (originally  filed with Amendment No. 1 to Form S-1 dated 3/20/01) (1)                                                                                                      |
| Exhibit  10.2   |   | Restated  Mortgage and Security Agreement dated September 21, 1988, made by and  between the Cooperative and National Rural Utilities Cooperative Finance  Corporation (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)  (1)                                                                         |
| Exhibit  10.3   |   | Second  Restated Mortgage and Security Agreement dated October 24, 1995, made by  and between the Cooperative and National Rural Utilities Cooperative Finance  Corporation (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)  (1)                                                                    |
| Exhibit  10.4   |   | Loan  Agreement dated October, 1995, between the Cooperative and National Rural  Utilities Cooperative Finance Corporation (originally filed with Form S-1  date July 31, 2001) (1)                                                                                                                                   |
| Exhibit  10.5   |   | First  Amendment to Loan Agreement dated as of October 28, 1997, between the  Cooperative and National Rural Utilities Cooperative Finance Corporation  (originally filed with Form S-1 date July 31, 2001) (1)                                                                                                  |
| Exhibit  10.6   |   | Loan  Agreement dated as of June 22, 2000, between the Cooperative and  National Rural Utilities Cooperative Finance Corporation and amendment. (originally  filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                 |
| Exhibit  10.7   |   | Loan  Agreement dated December 13, 1994, between the Cooperative and National  Rural Utilities Cooperative Finance Corporation (originally filed with Form  S-1 date July 31, 2001) (1)                                                                                                                          |
| Exhibit  10.8   |   | Loan  Agreement dated March 30, 1993 between the Cooperative and National  Rural Utilities Cooperative Finance Corporation (originally filed with Form  S-1 date July 31, 2001) (1)                                                                                                                              |
| Exhibit  10.9   |   | Loan  Agreement dated March 10, 1992, TX 107-A-9025, between the Cooperative  and National Rural Utilities Cooperative Finance Corporation (originally  filed with Amendment No. 1 to Form S-1 dated 3/20/01) (1)                                                                                                     |
| Exhibit  10.10  |   | Loan  Agreement dated May 17, 1990, between the Cooperative and National Rural  Utilities Cooperative Finance Corporation (originally filed with Amendment  No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                                            |
| Exhibit  10.11  |   | Loan  Agreement dated March 22, 1990 between the Cooperative and National  Rural Utilities Cooperative Finance Corporation (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                                      |
| Exhibit  10.12  |   | Notice  of Meeting and Proxy Statement for Special Meeting held October 20, 1998  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01) (1)                                                                                                                                                               |
| Exhibit  10.13  |   | Commitment  letter dated as of February 11, 2000 between National Cooperative  Services Corporation and Cap Rock Energy Corporation for credit facilities  associated with the purchase of certain electric assets owned by Citizens  Utilities Company (originally filed with Form S-1 date July 31, 2001)  (1) |

 

27

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| Exhibit  10.14  |   | Loan  Agreement dated March 10, 1992, TX 107-A-9026, between the Cooperative  and National Rural Utilities Cooperative Finance Corporation (originally filed  with Amendment No. 2 to Form S-1 dated 4/25/01) (1)                         |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit  10.15  |   | Purchase  and Sale Agreement dated as of February 11, 2000 between the Company,  the Cooperative and Citizens Utilities Company regarding Arizona Electric  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)          |
| Exhibit  10.16  |   | Purchase  and Sale Agreement dated as of February 11, 2000 between the Company,  the Cooperative and Citizens Utilities Company regarding Vermont Electric.  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)         |
| Exhibit  10.17  |   | Power  Sale Agreement dated May 1, 1999, between the Cooperative and Electric  Clearinghouse, Inc. (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01)(1)                                                                       |
| Exhibit  10.18  |   | Wholesale  Power Supply and Services Contract dated April 16, 1997 Between Texas  New Mexico Power Company and the Cooperative (originally filed with Amendment  No. 1 to Form S-1 dated 3/20/01)(1)                                      |
| Exhibit  10.19  |   | Southwestern  Public Service Company Wholesale Full Requirements Service Rate Schedule and  related Agreement, as amended, with the Cooperative (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                     |
| Exhibit  10.20  |   | Ordinance  of the City of Greenville, Texas Granting to the Cooperative a franchise for  the transmission and distribution of electricity (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                |
| Exhibit  10.21  |   | Ordinance  of the City of Midland, Texas Granting to the Cooperative a franchise for the  transmission and distribution of electricity (originally filed with Amendment  No. 1 to Form S-1 dated 3/20/01)(1)                                   |
| Exhibit  10.22  |   | Ordinance  of the City of Stanton, Texas Granting to the Cooperative a franchise for the  transmission and distribution of electricity (originally filed with Form S-1  date July 31, 2001) (1)                                           |
| Exhibit  10.23  |   | Employment  Contract between the Cooperative and Ulen North dated July 21, 1992  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                     |
| Exhibit  10.23a |   | Employment  Contract between Cap Rock Energy Corporation and Ulen A. North, Jr. dated  September 12, 2001 (2)                                                                                                                             |
| Exhibit  10.24  |   | Employment  Contract between the Cooperative and David W. Pruitt dated August 3,  1992 (originally filed with Amendment No. 2 to Form S-1 dated 4/25/01) (1)                                                                              |
| Exhibit 10.24a  |   | Employment Contract  between Cap Rock Energy Corporation and David W. Pruitt dated  September 11, 2001 (2)                                                                                                                                |
| Exhibit  10.25  |   | Achievement  Based Compensation Agreement Corporate Asset Non-CFC Financing Arrangements  dated August 28, 1994 (originally filed with Form S-1 date July 31,  2001) (1)                                                             |
| Exhibit  10.26  |   | Achievement  Based Compensation Agreement Corporate Asset Non-CFC Financing Arrangements  dated October 27, 1992 (originally filed with Form S-1 date  July 31, 2001) (1)                                                            |
| Exhibit  10.27  |   | The  Cooperatives Supplemental Executive Deferred Compensation Retirement Plan  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                           |
| Exhibit  10.28  |   | Cap  Rock Energy Corporation 2001 Stock Incentive Plan (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                                   |
| Exhibit  10.29  |   | Cap  Rock Energy Corporation 2001 Employee Stock Purchase Plan (originally filed  with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                           |
| Exhibit  10.30  |   | Form  of Equity & Membership Redemption Options (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                                      |
| Exhibit  10.31  |   | Form  of Equity Redemption Options (originally filed with Amendment No. 1 to Form  S-1 dated 3/20/01)(1)                                                                                                                                       |
| Exhibit  10.32  |   | Agreement  for Purchase and Sale dated February 7, 2000, by and among Walter  Mickelson, et al., Multimedia Development Corporation and New West Resources,  Inc. (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)    |
| Exhibit  10.33  |   | Stock  Acquisition Agreement dated January 1, 2001, between Thomas E. Kelly,  Richard C. Skillern, Johnny D. Grimes, Billy D. Grimes and New West  Resources, Inc. (originally filed with Amendment No. 2 to Form S-1 dated  4/25/01) (1) |
| Exhibit  10.34  |   | Consolidating  Loan Agreement dated March 30, 1993 between Cap Rock Electric  Cooperative, Inc. and National Rural Utilities Cooperative Finance Corporation  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)        |

 

28

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| Exhibit  10.35 |   | Integrated  Supply Agreement between Cap Rock Electric Cooperative, Inc. and Temple, Inc.  (originally filed with Amendment No. 2 to Form S-1 dated 4/25/01) (1)                                                                      |
|----------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit  10.36 |   | Employment  Contract between the Cooperative and Mickey Sims (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                                    |
| Exhibit  10.37 |   | Amendment  to Line of Credit Agreement dated June 27, 1997 between National Rural  Utilities Cooperative Finance Corporation and the Cooperative (originally  filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)           |
| Exhibit  10.38 |   | Loan  Agreement dated March 10, 1992, TX 107-A-9027, between the Cooperative  and National Rural Utilities Cooperative Finance Corporation (originally  filed with Amendment No. 2 to Form S-1 dated 4/25/01) (1)                |
| Exhibit  10.39 |   | Achievement  Based Compensation Contract, Merger or Acquisition with Other Electric  Utilities dated August 22, 2000 (originally filed with Amendment No. 1  to Form S-1 dated 3/20/01)(1)                                       |
| Exhibit  10.40 |   | Loan  Agreement dated March 10, 1992, TX 107-A-9024, between Cooperative and  National Rural Utilities Cooperative Finance Corporation (originally filed  with Amendment No. 2 to Form S-1 dated 4/25/01) (1)                    |
| Exhibit  10.41 |   | Wholesale  Power Agreement dated June 25, 1977, between Lower Colorado River  Authority and McCulloch Electric Cooperative, Inc. (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                           |
| Exhibit  10.42 |   | Amendment  to Wholesale Power Agreement dated September 28, 1987 between Lower  Colorado River Authority and McCulloch Electric Cooperative, Inc. (originally  filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)          |
| Exhibit  10.43 |   | Director  Compensation Plan of the Company (originally filed with Amendment No. 1 to  Form S-1 dated 3/20/01)(1)                                                                                                                      |
| Exhibit  10.44 |   | Trust  Agreement for the Cooperative Supplemental Executive Deferred Compensation  Retirement Plan (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01)(1)                                                              |
| Exhibit  10.45 |   | CFC  Secured Revolving Line of Credit Agreement dated June 24, 1997  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                        |
| Exhibit  10.46 |   | Achievement  Based Compensation Contract, Merger or Acquisition with Other Electric  Utilities dated June 29, 1999 (originally filed with Amendment No. 1 to  Form S-1 dated 3/20/01)(1)                                         |
| Exhibit  10.47 |   | Agreement  to Combine McCulloch and Cap Rock Electric Cooperatives dated June 30,  1999 (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                     |
| Exhibit  10.48 |   | Management  Service Agreement between Cooperative and Lamar Electric Cooperative  Association (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01)(1)                                                                   |
| Exhibit  10.49 |   | Notice  of Annual Meeting and Proxy Statement for Members of McCulloch Electric  Cooperative held on August 21, 1999 (originally filed with Amendment No.  1 to Form S-1 dated 3/20/01)(1)                                       |
| Exhibit  10.50 |   | Agreement  to Combine Lamar and Cap Rock Electric Cooperatives dated October 28,  1999 (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                      |
| Exhibit  10.51 |   | Loan  Agreement between New West Resources, Inc, Cap Rock Electric Cooperative,  Inc. and Bank United Texas FSB dated July 12, 2000 (originally filed  with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                        |
| Exhibit  10.52 |   | Unconditional  Guaranty from Cap Rock Electric Cooperative to Bank United Texas FSB dated  July 12, 2000 (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01) (1)                                                  |
| Exhibit  10.53 |   | Lamar  County Electric Cooperative Association Notice of Special Meeting and Proxy  Statement for Special Meeting held December 14, 1999 (originally filed  with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                   |
| Exhibit  10.54 |   | Signature  Leasing, Inc. Master Lease Agreement dated April 1, 2000 (originally  filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                        |
| Exhibit  10.55 |   | Personal  Services Agreement between Leonard S. Herring and the Cooperative dated  December 16, 1999 (originally filed with Amendment No. 1 to Form S-1  dated 3/20/01)(1)                                                       |
| Exhibit  10.56 |   | Term  Loan Agreement between Eddins-Walcher Company, Frank’s Fuels, United Fuel  & Energy Corporation, and New West Resources dated July 12, 2000  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1) |
| Exhibit  10.57 |   | NewCorp  Resources Electric Cooperative Open Access Transmission Tariff (originally  filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                                         |
| Exhibit  10.58 |   | Supplement  to the Restated Mortgage and Security Agreement between the Cooperative                                                                                                                                                   |

 

29

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|            |   | and  CFC dated May 17, 1990 (originally filed with Amendment No. 1 to Form S-1  dated 3/20/01)(1)                                                                                                                                    |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit  10.59  |   | Loan  Agreement between Cap Rock Cooperative Finance Corporation and CFC dated  June 22, 1999 (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01)(1)                                                             |
| Exhibit  10.60  |   | Confirmation  Letter between Electric Clearinghouse, Inc. and the Cooperative dated May 27,  1999 (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                               |
| Exhibit  10.61  |   | Service  Agreement Rate Schedule WP between NewCorp Resources and Cap Rock  Electric Cooperative dated March 31, 1995 (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                |
| Exhibit  10.62  |   | Transaction  Agreement dated as of September 9, 1993 between Southwestern Public  Service Company, the Cooperative and OTP, Inc. (originally filed with  Amendment No. 1 to Form S-1 dated 3/20/01)(1)                          |
| Exhibit  10.63  |   | Assignment  of Certificate of Convenience and Necessity by the Cooperative to NewCorp  Resources dated January 17, 1996 (originally filed with Amendment No. 1  to Form S-1 dated 3/20/01)(1)                                   |
| Exhibit  10.64  |   | Supplemental  Agreement between NewCorp Resources and the Cooperative dated April 25,  1995 (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                |
| Exhibit  10.65  |   | Third  Amendment to Transaction Documents by and among Southwestern Public Service  Company, the Cooperative, NewCorp Resources et al dated March 3, 1995  (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1) |
| Exhibit  10.66  |   | Assignment  of Wholesale Power Contract from the Cooperative to NewCorp Resources dated  March 3, 1995 (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01)(1)                                                    |
| Exhibit  10.67  |   | QSE  and Ancillary Services Agreement between the Cooperative and Garland Power  and Light dated June 1, 2001 (originally filed with Amendment No. 2 to  Form S-1 dated 4/25/01) (1)                                            |
| Exhibit  10.68  |   | Letter  of Intent between the Company and Boeing Capital Corporation dated  June 5, 2001(1)                                                                                                                                     |
| Exhibit  10.69  |   | Employment  Contract between the Company and Lee D. Atkins dated September 1, 2001  (originally filed with Post Effective Amendment No. to Form S-1 dated  12/31/01) (1)                                                        |
| Exhibit  10.70  |   | Employment  Contract between the Company and Ronald W. Lyon(originally filed with Post  Effective Amendment No. 1 to Form S-1 dated 12/31/01) (1)                                                                                    |
| Exhibit  10.70a |   | Employment  Contract between Cap Rock Energy Corporation and Ronald Lyon dated  October 24, 2001 (2)                                                                                                                            |
| Exhibit  10.71  |   | Employment  Contract between the Company and Sam Prough dated September 14, 2001 (originally  filed with Post Effective Amendment No. to Form S-1 dated 12/31/01) (1))                                                          |
| Exhibit  10.72  |   | Achievement  Based Compensation Agreement Corporate Asset Non-CFC Financing Arrangements  dated August 21, 2001 (originally filed with Post Effective Amendment No.  1 to Form S-1 dated 12/31/01) (1)                          |
| Exhibit  10.73  |   | Letter  from State Securities Board of the State of Texas dated December 6, 2001  (originally filed with Post Effective Amendment No. 1 to Form S-1 dated  12/31/01) (1)                                                        |
| Exhibit  10.74  |   | Employment  Contract between the Company and Celia A. Zinn dated September 20, 2001  (originally filed with Form 10-K for period ended 12/31/02 dated 4/10/03) (1)                                                              |
| Exhibit  10.75  |   | Cap  Rock Energy Corporation Shareholders’ Trust (originally filed with Form 10-K  for period ended 12/31/02 dated 4/10/03) (1)                                                                                                 |
| Exhibit  10.76  |   | Cap  Rock Energy Corporation Trust Share Option Agreement (originally filed with  Form 10-K for period ended 12/31/02 dated 4/10/03) (1)                                                                                             |
| Exhibit  10.77  |   | Cap  Rock Energy Corporation Trust Funding Agreement (1)                                                                                                                                                                             |
| Exhibit  10.78  |   | Supplemental  Executive Deferred Compensation Retirement Plan dated November 14, 2002  (originally filed with Form 10-K for period ended 12/31/02 dated 4/10/03)(1)                                                             |
| Exhibit  10.79  |   | Beal  Bank Loan Agreements dated September 8, 2003 (originally filed with Form  10-Q for the period ended 9/30/03 dated 11/13/03) (1)                                                                                           |
| Exhibit  10.80  |   | Washington  Mutual Modification and Extension Agreement dated October 9, 2003  (originally filed with Form 10-Q for the period ended 9/30/03 dated 11/13/03)  (1)                                                               |
| Exhibit  10.81  |   | Achievement  Based Compensation Contract, Southwestern Public Service Company Contract  dated October 27, 992 (originally filed with Form 10-K for the period  ended 12/31/03 dated March 30, 2004)(2)                     |
| Exhibit  10.82  |   | Managed  Services Agreement with Delinea Corporation dated March 12, 2003 (2)                                                                                                                                                   |
| Exhibit  10.83  |   | Master  Operation, Maintenance and Administrative Services Agreement dated  September 29, 2003 between Cap Rock Energy Corporation and NewCorp  Resources Electric Cooperative, Inc. (2)                                        |
| Exhibit  10.84  |   | Stock  Acquisition Agreement between New Corp Resources Electric Cooperative, Inc.  and United Fuel and Energy Corporation dated March 18, 2004 (2)                                                                                  |

 

30

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| Exhibit  14.1 |   | Cap  Rock Energy Corporation Code of Ethics dated December 2, 2003 (2)                                                                               |
|---------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit  18.1 |   | Change  in Accounting Principle Letter from KPMG LLP (originally filed with Form 10-Q  dated 5/15/03)(1)                                                  |
| Exhibit  20.1 |   | Election  Form (originally filed with Amendment No. 1 to Form S-1 dated 3/20/01)(1)                                                                       |
| Exhibit  21.1 |   | Subsidiaries  of the Company (originally filed with Amendment No. 1 to Form S-1 dated  3/20/01)(1)                                                        |
| Exhibit  23.2 |   | Consent  of Ronald W. Lyon is contained in his opinion filed as Exhibit 5.1 to this  registration statement.(1)                                           |
| Exhibit  23.3 |   | Consent  of Bolinger, Segars, Gilbert & Moss, L.L.P. (originally filed with  Amendment No. 2 to Form S-1 dated 4/25/01) (1)                           |
| Exhibit  23.4 |   | Consent  of Looper Reed & McGraw (originally filed with Amendment No. 2 to Form  S-1 dated 4/25/01) (1)                                               |
| Exhibit  31.1 |   | Certification  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 of David W. Pruitt (2) |
| Exhibit  31.2 |   | Certification  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 of Lee D. Atkins (2)   |
| Exhibit  32.1 |   | Certification  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 of David W. Pruitt)(2) |
| Exhibit  32.2 |   | Certification  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 of Lee D. Atkins (2)   |

 

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(1)                                  Previously filed

 

(2)                                  Filed herewith

 

31

----

 

**SIGNATURES**

 

Inaccordance with the requirements of the Securities Act of 1934, as amended, theRegistrant certifies that it has reasonable grounds to believe that it meetsall of the requirements for filing Form 10K and authorizes this Form 10K to besigned on its behalf by the undersigned, thereunto duly authorized, in the Cityof Midland, Texas, on March 29, 2004.

 
|   | **CAP ROCK  ENERGY CORPORATION**           |
|--------|--------------------------------------------|
|   |                                       |
|   | By:                                        |
|   | /s/ DAVID W. PRUITT                        |
|   | David W. Pruitt                            |
|   | *Co-Chairman of the Board,  President And* |
|   | *Chief Executive Officer*                  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934 this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**            |   | **Title**                                                     |   | **Date**            |
|--------------------------|--------|---------------------------------------------------------------|--------|---------------------|
|                     |   |                                                          |   |                |
| /s/ David W. Pruitt      |   | Co-Chairman of the Board, President and                       |   | March 29, 2004 |
| David W. Pruitt          |   | Chief Executive Officer                                       |   |                |
|                     |   |                                                          |   |                |
| *                        |   | Senior Vice President, Chief Financial Officer  and Treasurer |   | March 29, 2004 |
| /s/ Lee D. Atkins        |   |                                                          |   |                |
|                     |   |                                                          |   |                |
| *                        |   | Co-Chairman of the Board                                      |   | March 29, 2004 |
| /s/ Russell E. Jones     |   |                                                          |   |                |
|                     |   |                                                          |   |                |
| *                        |   | Director                                                      |   | March 29, 2004 |
| /s/ S. D. Buchanan       |   |                                                          |   |                |
|                     |   |                                                          |   |                |
| *                        |   | Director                                                      |   | March 29, 2004 |
| /s/ Floyd L. Ritchey     |   |                                                          |   |                |
|                     |   |                                                          |   |                |
| *                        |   | Director                                                      |   | March 29, 2004 |
| /s/ Michael D. Schaffner |   |                                                          |   |                |
|                     |   |                                                          |   |                |
| *                        |   | Director                                                      |   | March 29, 2004 |
| /s/ Newell W. Tate       |   |                                                          |   |                |

 

32

----

 

**CAP ROCKENERGY CORPORATION**

**SCHEDULE II—VALUATIONAND QUALIFYING ACCOUNTSALLOWANCE FOR DOUBTFUL ACCOUNTS(AMOUNTS STATED IN THOUSANDS)**

 
| **COLUMN A-  DESCRIPTION** |   | **COLUMN B-  BALANCE AT  BEGINNING OF  PERIOD** |   | **COLUMN C-  CHARGED TO  COSTS AND  EXPENSES** |   | **COLUMN D-  DEDUCTION-  CHARGED-  OFF** |   | **COLUMN E-  BALANCE AT  END OF  PERIOD** |   |
|----------------------------|--------|-------------------------------------------------|--------|------------------------------------------------|--------|------------------------------------------|--------|-------------------------------------------|--------|
| December 31,  2003    |   | $                                               | 50     |                                           | $      | 113                                      |   | $                                         | 85     |   | $ | 78 |   |
| December 31,  2002    |   | $                                               | 202    |                                           | $      | 113                                      |   | $                                         | 265    |   | $ | 50 |   |
| December 31,  2001    |   | $                                               | 292    |                                           | $      | 107                                      |   | $                                         | 197    |   | $ | 202 |   |

 

33

----

 

**INDEX TOFINANCIAL STATEMENTS**

 
| Independent Auditors’  Report, KPMG LLP                                               |   |   |
|--------------------------------------------------------------------------------------------|--------|--------|
|                                                                                       |   |   |
| Report of  Independent Public Accountants, Arthur Andersen LLP                             |   |   |
|                                                                                       |   |   |
| Consolidated  Statements of Operations                                                     |   |   |
| Years ended  December 31, 2003 and 2002, and nine months ended December 31, 2001 |   |   |
|                                                                                       |   |   |
| Consolidated Balance Sheets                                                                |   |   |
| December 31, 2003 and  2002                                                           |   |   |
|                                                                                       |   |   |
| Consolidated Statement  of Equity                                                          |   |   |
| Years ended  December 31, 2003 and 2002, and nine months ended December 31, 2001 |   |   |
|                                                                                       |   |   |
| Consolidated  Statements of Cash Flows                                                     |   |   |
| Years ended  December 31, 2003 and 2002, and nine months ended December 31, 2001 |   |   |
|                                                                                       |   |   |
| Notes to  Consolidated Financial Statements                                                |   |   |

 

F - 1

----

 

**INDEPENDENTAUDITORS’ REPORT**

 

Tothe Board of Directors ofCap Rock Energy Corporation:

 

Wehave audited the accompanying consolidated balance sheets of Cap Rock EnergyCorporation and subsidiaries as of December 31, 2003 and 2002, and therelated consolidated statements of income, stockholders’ equity, and cash flowsfor the years then ended.  Theseconsolidated financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.  The December 31, 2001,consolidated financial statements were audited by other auditors who haveceased operations and whose report, dated March 29, 2002, expressed anunqualified opinion on those consolidated financial statements.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States of America.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatements.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Cap Rock EnergyCorporation and subsidiaries as of December 31, 2003 and 2002, and theresults of their operations and their cash flows for the years then ended inconformity with accounting principles generally accepted in the United Statesof America.

 

Asdiscussed in Note 1 to the financial statements, the Company changed its methodof accounting for unbilled revenue in 2003.

 

 
|                 | KPMG  LLP |
|----------------------|-----------|
|                 |      |
|                 |      |
| Midland,  Texas      |      |
| March 29,  2004 |      |

 

F - 2

----

 

Thisis a copy of the report previously issued by Arthur Andersen LLP.  The report has not been reissued by ArthurAndersen LLP nor has Arthur Andersen LLP provided a consent to the inclusion ofits report in this annual report on Form 10-K.

 

**REPORT OFINDEPENDENT PUBLIC ACCOUNTANTS**

 

Tothe Board of Directors ofCap Rock Electric Cooperative, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Cap Rock ElectricCooperative, Inc. and subsidiaries (the “Cooperative”) as of December 31,2001, and March 31, 2001, and the related consolidated statements ofoperations, changes in equities and margins and cash flows for the nine monthsended December 31, 2001, and each of the two years in the period endedMarch 31, 2001. These financial statements and the schedule referredto below are the responsibility of the Cooperative’s management. Ourresponsibility is to express an opinion on these financial statements andschedule based on our audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States. Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. Anaudit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of the Cooperative asof December 31, 2001, and March 31, 2001, and the results of itsoperations and its cash flows for the nine months ended December 31, 2001,and each of the two years in the period ended March 31, 2001, inconformity with accounting principles generally accepted in the United States.

 

Ouraudit was made for the purpose of forming an opinion on the basic financialstatements taken as a whole. The Valuation and Qualifying Accounts,Schedule II is presented for purposes of additional analysis and is not arequired part of the basic financial statements. This information has beensubjected to the auditing procedures applied in our audit of the basicfinancial statements and, in our opinion, is fairly stated in all materialrespects in relation to the basic financial statements taken as a whole.

 

Asexplained in Note 1. to the consolidated financial statements, effectiveApril 1, 2001, the Cooperative adopted Statement of Financial AccountingStandards No. 133, “Accounting for Derivative Instruments and HedgingActivities,” as amended.

 

 
|                 | Arthur  Andersen LLP |
|----------------------|----------------------|
|                 |                 |
|                 |                 |
| Dallas,  Texas       |                 |
| March 29,  2002 |                 |

 

F - 3

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
|                                                             |   | **YEAR ENDED DECEMBER 31,**                              |   | **NINE MONTHS  ENDED  DECEMBER 31,** |   |
|------------------------------------------------------------------|--------|---------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                             |   | **2003**                                                      |   | **2002**                                  |   | **2001** |   |
|                                                             |   | **Successor**                                                 |   | **Successor**                             |   | **Predecessor** |   |
|                                                             |   | **(Thousands of dollars except share and per share amounts)** |   |
| **Operating Revenues:**                                          |   |                                                          |   |                                      |   |   |   |
| Electric sales                                                   |   | $                                                             | 81,402 |                                      | $      | 73,335 |   | $ | 52,326 |   |
| Other                                                            |   | 1,450                                                         |   | 1,302                                     |   | 796 |   |
| Total operating revenues                                         |   | 82,852                                                        |   | 74,637                                    |   | 53,122 |   |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Operating Expenses:**                                          |   |                                                          |   |                                      |   |   |   |
| Purchased power                                                  |   | 36,578                                                        |   | 36,433                                    |   | 28,194 |   |
| Operations and maintenance                                       |   | 10,476                                                        |   | 7,327                                     |   | 5,828 |   |
| General and administrative                                       |   | 6,471                                                         |   | 7,144                                     |   | 3,326 |   |
| Depreciation and amortization                                    |   | 7,787                                                         |   | 6,134                                     |   | 4,568 |   |
| Property taxes                                                   |   | 1,345                                                         |   | 1,367                                     |   | 997 |   |
| Impairment of Lamar  combination costs (Note 5)                  |   | —                                                        |   | 1,357                                     |   | — |   |
| Other                                                            |   | 326                                                           |   | 202                                       |   | 229 |   |
| Total operating expenses                                         |   | 62,983                                                        |   | 59,964                                    |   | 43,142 |   |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Operating Income**                                             |   | 19,869                                                        |   | 14,673                                    |   | 9,980 |   |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Other Income (Expense):**                                      |   |                                                          |   |                                      |   |   |   |
| Allocation of income from  associated organizations              |   | 530                                                           |   | 478                                       |   | 1,205 |   |
| Interest expense, net of  capitalized interest                   |   | (6,979                                                        | )      | (7,103                                    | )      | (8,004 | ) |
| Interest and other income                                        |   | 788                                                           |   | 1,027                                     |   | 1,161 |   |
| Loss on sale of MAP stock                                        |   | (1,056                                                        | )      | —                                    |   | — |   |
| Equity earnings in MAP (Notes  9 and 24)                         |   | 144                                                           |   | 115                                       |   | 88 |   |
| Total other income (expense)                                     |   | (6,573                                                        | )      | (5,483                                    | )      | (5,550 | ) |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Income before income taxes**                                   |   | 13,296                                                        |   | 9,190                                     |   | 4,430 |   |
| Income tax expense                                               |   | 2,098                                                         |   | 414                                       |   | — |   |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Net Income**                                                   |   | $                                                             | 11,198 |                                      | $      | 8,776 |   | $ | 4,430 |   |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Net income per common share:**                                 |   |                                                          |   |                                      |   |   |   |
| Basic                                                            |   | $                                                             | 7.69   |                                      | $      | 6.74 |   |   |   |
| Diluted                                                          |   | $                                                             | 7.41   |                                      | $      | 6.74 |   |   |   |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Weighted average number of shares outstanding:**               |   |                                                          |   |                                      |   |   |   |
| Basic                                                            |   | 1,455,443                                                     |   | 1,302,355                                 |   |   |   |
| Diluted                                                          |   | 1,510,741                                                     |   | 1,302,355                                 |   |   |   |
|                                                             |   |                                                          |   |                                      |   |   |   |
| **Pro forma Basic and Diluted  Earnings Per Share (Unaudited):** |   |                                                          |   |                                      |   |   |   |
| Net income per share                                             |   |                                                          |   |                                      |   | $ | 3.40 |   |
| Pro forma shares outstanding                                     |   |                                                          |   |                                      |   | 1,302,355 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F - 4

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

 
|                                                                                                                                                                                                                |   | **DECEMBER 31,**       |    |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                                                                                                                |   | **2003**                    |    | **2002** |   |
|                                                                                                                                                                                                                |   | **Successor**               |    | **Successor** |   |
|                                                                                                                                                                                                                |   | **(Thousands of  dollars)** |    |
| **ASSETS**                                                                                                                                                                                                          |   |                        |    |   |   |
|                                                                                                                                                                                                                |   |                        |    |   |   |
| **Current Assets:**                                                                                                                                                                                                 |   |                        |    |   |   |
| Cash                                                                                                                                                                                                                |   | $                           | 12,170  |   | $ | 9,899 |   |
| Restricted  cash investment                                                                                                                                                                                         |   | 14,169                      |    | — |   |
| Accounts  receivable:                                                                                                                                                                                               |   |                        |    |   |   |
| Electric  sales, net                                                                                                                                                                                                |   | 8,500                       |    | 4,680 |   |
| Other                                                                                                                                                                                                               |   | 371                         |    | 380 |   |
| Current  notes receivable (Note 8 and 14)                                                                                                                                                                           |   | 1,250                       |    | 12,490 |   |
| Purchased  power subject to recovery                                                                                                                                                                                |   | —                      |    | 3,501 |   |
| Other  current assets (Note 7)                                                                                                                                                                                      |   | 1,587                       |    | 8,735 |   |
| **Total current assets**                                                                                                                                                                                            |   | 38,047                      |    | 39,685 |   |
|                                                                                                                                                                                                                |   |                        |    |   |   |
| **Utility plant, net (Note 9)**                                                                                                                                                                                     |   | 152,162                     |    | 156,517 |   |
| **Investments and notes receivable (Note 8)**                                                                                                                                                                       |   | 10,045                      |    | 12,490 |   |
| **Nonutility property, net (Note 10)**                                                                                                                                                                              |   | 1,545                       |    | 1,564 |   |
| **Other assets and deferred charges (Note 11)**                                                                                                                                                                     |   | 1,190                       |    | 1,038 |   |
| **Total Assets**                                                                                                                                                                                                    |   | $                           | 202,989 |   | $ | 211,294 |   |
|                                                                                                                                                                                                                |   |                        |    |   |   |
| **LIABILITIES  AND EQUITY**                                                                                                                                                                                         |   |                        |    |   |   |
|                                                                                                                                                                                                                |   |                        |    |   |   |
| **Current Liabilities:**                                                                                                                                                                                            |   |                        |    |   |   |
| Current  portion of long-term debt                                                                                                                                                                                  |   | $                           | 4,654   |   | $ | 33,924 |   |
| Short-term  note payable                                                                                                                                                                                            |   | 14,169                      |    | — |   |
| Accounts  payable:                                                                                                                                                                                                  |   |                        |    |   |   |
| Purchased  power                                                                                                                                                                                                    |   | 2,798                       |    | 3,381 |   |
| Other                                                                                                                                                                                                               |   | 2,679                       |    | 1,796 |   |
| Equity  redemption credits (Note 2)                                                                                                                                                                                 |   | —                      |    | 732 |   |
| Purchased  power cost subject to refund                                                                                                                                                                             |   | 203                         |    | — |   |
| Accrued  and other current liabilities (Note 15)                                                                                                                                                                    |   | 3,902                       |    | 3,066 |   |
| Current  income tax payable (Note 24)                                                                                                                                                                               |   | 562                         |    | 414 |   |
| **Total current liabilities**                                                                                                                                                                                       |   | 28,967                      |    | 43,313 |   |
|                                                                                                                                                                                                                |   |                        |    |   |   |
| **Long-Term Debt, Net of Current Portion:**                                                                                                                                                                         |   |                        |    |   |   |
| Mortgage  notes (Note 12)                                                                                                                                                                                           |   | 143,188                     |    | 147,744 |   |
| Note  payable and other capital leases (Note 14)                                                                                                                                                                    |   | 184                         |    | 308 |   |
| **Total long-term debt**                                                                                                                                                                                            |   | 143,372                     |    | 148,052 |   |
|                                                                                                                                                                                                                |   |                        |    |   |   |
| **Deferred Credits (Note 17)**                                                                                                                                                                                      |   | 3,677                       |    | 5,191 |   |
|                                                                                                                                                                                                                |   |                        |    |   |   |
| **Stockholders’ Equity:**                                                                                                                                                                                      |   |                        |    |   |   |
| Preferred  stock, par value $1 per share, 50,000,000 shares authorized, no shares issued  or outstanding                                                                                                            |   | —                      |    | — |   |
| Common  stock, par value $.01 per share, 50,000,000 shares authorized, 1,302,355  shares issued and outstanding at December 31, 2002 and 1,650,395 issued  and 1,567,725 outstanding at December 31, 2003 |   | 17                          |    | 13 |   |
| Paid  in capital                                                                                                                                                                                                    |   | 11,641                      |    | 5,949 |   |
| Retained  earnings                                                                                                                                                                                                  |   | 19,974                      |    | 8,776 |   |
| Less  Deferred compensation                                                                                                                                                                                         |   | (3,826                      | )       | — |   |
| Less  Treasury stock of 82,670 shares                                                                                                                                                                               |   | (833                        | )       | — |   |
| **Total stockholders’ equity**                                                                                                                                                                                 |   | 26,973                      |    | 14,738 |   |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                                 |   | $                           | 202,989 |   | $ | 211,294 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F - 5

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATEDSTATEMENT OF EQUITY**

 
|                                                                                                             |   | **(Thousands of dollars except number of shares)** |   |
|------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------|--------|
|                                                                                                             |   | **Successor**                                      |   | **Predecessor** |   |
|                                                                                                             |   |                                               |   |   |   |   |   |   |   | **Total** |   | **Patronage** |   | **Other** |   | **Patronage Capital  Obligated to be** |   | **Total  Margins** |   |
|                                                                                                             |   | **Common Stock**                                   |   | **Paid in** |   | **Retained** |   | **Stockholders’** |   | **Capital** |   | **Equities and** |   | **converted to** |   | **and** |   |
|                                                                                                             |   | **# shares**                                       |   | **Value** |   | **Capital** |   | **Earnings** |   | **Equity** |   | **Credits** |   | **Margins** |   | **Shareholder Equity** |   | **Equities** |   |
| **Balance, March 31, 2001**                                                                                 |   |                                               |   |   |   |   |   |   |   |   |   | $ | 15,480 |   | $ | (9,805 | ) |   |   | $ | 5,675 |   |
| Patronage capital  credits retired for electric credits                                                          |   |                                               |   |   |   |   |   |   |   |   |   | (909 | ) | — |   |   |   | (909 | ) |
| Patronage capital  credits retired for cash                                                                      |   |                                               |   |   |   |   |   |   |   |   |   | (2,181 | ) | 657 |   |   |   | (1,524 | ) |
| Patronage capital  obligated to be converted into shareholder equity (Note 2)                                    |   |                                               |   |   |   |   |   |   |   |   |   | (12,390 | ) | — |   | 12,390 |   | — |   |
| Net income for nine months                                                                                       |   |                                               |   |   |   |   |   |   |   |   |   | — |   | 4,430 |   |   |   | 4,430 |   |
| **Balance, December 31, 2001**                                                                              |   |                                               |   |   |   |   |   |   |   |   |   | — |   | (4,718 | ) | 12,390 |   | 7,672 |   |
| Issuance of the  Company’s common stock to the Cooperative in                                               |   | 1,302,355                                          |   | $ | 13 |   | $ | (13 | ) | $ | — |   | $ | — |   |   |   |   |   |   |   |   |   |
| exchange for its net assets and  liabilities                                                                     |   |                                               |   |   |   | (4,718 | ) |   |   | (4,718 | ) |   |   | 4,718 |   |   |   | 4,718 |   |
| Conversion costs                                                                                                 |   |                                               |   |   |   | (1,685 | ) |   |   | (1,685 | ) |   |   |   |   |   |   |   |   |
| Distribution by the  Cooperative of shares of the Company’s common stock to the Cooperative’s  members |   |                                               |   |   |   | 12,390 |   |   |   | 12,390 |   |   |   |   |   | (12,390 | ) | (12,390 | ) |
| Payments to former  Cooperative members for fractional shares and other redemption equity                        |   |                                               |   |   |   | (25 | ) |   |   | (25 | ) |   |   |   |   |   |   |   |   |
| Net income                                                                                                       |   |                                               |   |   |   |   |   | 8,776 |   | 8,776 |   |   |   |   |   |   |   |   |   |
| **Balance, December 31, 2002**                                                                              |   | 1,302,355                                          |   | 13 |   | 5,949 |   | 8,776 |   | 14,738 |   | — |   | — |   | — |   | — |   |
|                                                                                                                  |        |                                                    |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

(continued)

 

F - 6

----

 
|                                                                                                                     |   | **(Thousands of dollars except number of shares)** |            |
|--------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------|-----------------|
|                                                                                                                     |   | **Successor**                                      |            |
|                                                                                                                     |   | **Common Stock**                                   |            | **Paid in  Capital** |   | **Retained  Earnings** |   | **Deferred  Compensation** |   | **Treasury Stock** |   | **Total  Stockholders’  Equity** |   |
| **# shares**                                                                                                             |   | **Value**                                          | **# of Shares** |   | **Value** |
| **Balance, December 31, 2002**                                                                                      |   | 1,302,355                                          |            | 13 |   | 5,949 |   | 8,776 |   |   |   |   |   |   |   | 14,738 |   |
| Repurchase of shares  through tender offer                                                                               |   |                                               |            |   |   |   |   |   |   |   |   | (82,140 | ) | (821 | ) | (821 | ) |
| Stock awarded through  Stock Incentive Plan, net of shares withheld for taxes and amortization of  deferred compensation |   | 348,940                                            |            | 4 |   | 5,720 |   |   |   | (3,826 | ) |   |   |   |   | 1,898 |   |
| Unvested shares  forfeited                                                                                               |   | (900                                               | )               |   |   | (9 | ) |   |   |   |   |   |   |   |   | (9 | ) |
| Repurchase of vested  shares issued through stock incentive plan                                                         |   |                                               |            |   |   |   |   |   |   |   |   | (260 | ) | (9 | ) | (9 | ) |
| Adjustment to original  converson distribution                                                                           |   |                                               |            |   |   | (19 | ) |   |   |   |   | (270 | ) | (3 | ) | (22 | ) |
| Net income                                                                                                               |   |                                               |            |   |   |   |   | 11,198 |   |   |   |   |   |   |   | 11,198 |   |
| **Balance, December 31, 2003**                                                                                      |   | 1,650,395                                          |            | $ | 17 |   | $ | 11,641 |   | $ | 19,974 |   | $ | (3,826 | ) | (82,670 | ) | $ | (833 | ) | $ | 26,973 |   |
|                                                                                                                          |        |                                                    |                 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F - 7

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
|                                                                               |   | **YEAR ENDED DECEMBER 31,**                                                                 |   | **NINE  MONTHS  ENDED  DECEMBER  31,** |   |
|------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                               |   | **2003**                                                                                         |   | **2002**                               |   | **2001** |   |
|                                                                               |   | **Successor**                                                                                    |   | **Successor**                          |   | **Predecessor** |   |
|                                                                               |   | **— — — — — (Thousands of  dollars)— — — — —** |   |
| **Cash Flows From Operating Activities:**                                          |   |                                                                                             |   |                                   |   |   |   |
| Net income                                                                         |   | $                                                                                                | 11,198 |                                   | $      | 8,776 |   | $ | 4,430 |   |
| Adjustments to reconcile net  income to net cash provided by operating activities: |   |                                                                                             |   |                                   |   |   |   |
| Depreciation and amortization                                                      |   | 10,772                                                                                           |   | 9,253                                  |   | 8,328 |   |
| Noncash deferred compensation  expense                                             |   | 2,020                                                                                            |   | —                                 |   | — |   |
| Write off of investments in  proposed acquisitions                                 |   | —                                                                                           |   | 1,357                                  |   | — |   |
| Equity earnings in Map                                                             |   | (144                                                                                             | )      | (115                                   | )      | (88 | ) |
| Loss on equity method  investment value                                            |   | 1,056                                                                                            |   | —                                 |   | — |   |
| Change in:                                                                         |   |                                                                                             |   |                                   |   |   |   |
| Other assets/deferred credits                                                      |   | (2,964                                                                                           | )      | 5,909                                  |   | 17 |   |
| Accounts receivable                                                                |   | (3,811                                                                                           | )      | (921                                   | )      | 2,370 |   |
| Purchased power cost subject  to refund                                            |   | 3,704                                                                                            |   | (3,888                                 | )      | (3,808 | ) |
| Other current assets                                                               |   | (1,059                                                                                           | )      | (6,386                                 | )      | (926 | ) |
| Accounts payable and accrued  expenses                                             |   | 1,284                                                                                            |   | (735                                   | )      | 934 |   |
| Net cash provided by operating  activities                                         |   | 22,056                                                                                           |   | 13,250                                 |   | 11,257 |   |
| **Cash Flows From Investing Activities**                                           |   |                                                                                             |   |                                   |   |   |   |
| Utility plant additions                                                            |   | (5,209                                                                                           | )      | (1,517                                 | )      | (4,257 | ) |
| Proceeds from liquidation of  investments                                          |   | 1,511                                                                                            |   | 1,043                                  |   | (76 | ) |
| Issuance of notes receivable                                                       |   | (1,250                                                                                           | )      | —                                 |   | — |   |
| Collection of notes receivable                                                     |   | 12,490                                                                                           |   | 1,000                                  |   | 2,100 |   |
| Net cash provided by (used in)  investing activities                               |   | 7,542                                                                                            |   | 526                                    |   | (2,233 | ) |
| **Cash Flows From Financing Activities:**                                          |   |                                                                                             |   |                                   |   |   |   |
| Net borrowings under lines of  credit                                              |   | —                                                                                           |   | —                                 |   | 40 |   |
| Proceeds from other long-term  debt and capital leases                             |   | 14,169                                                                                           |   | 534                                    |   | — |   |
| Payments on mortgage notes                                                         |   | (3,704                                                                                           | )      | (3,034                                 | )      | (2,320 | ) |
| Payments on other long-term  debt and capital leases                               |   | (30,246                                                                                          | )      | (6,387                                 | )      | (4,377 | ) |
| Restricted cash investment                                                         |   | (5,962                                                                                           | )      | —                                 |   | — |   |
| Repurchase/acquisition of  common stock                                            |   | (852                                                                                             | )      | —                                 |   | — |   |
| Retirement of former member  equity                                                |   | (732                                                                                             | )      | (488                                   | )      | (2,605 | ) |
| Net cash used in financing  activities                                             |   | (27,327                                                                                          | )      | (9,375                                 | )      | (9,262 | ) |
| **Increase (Decrease) in Cash and Cash  Equivalents:**                             |   | 2,271                                                                                            |   | 4,401                                  |   | (238 | ) |
| Cash at beginning of period                                                        |   | 9,899                                                                                            |   | 5,498                                  |   | 5,736 |   |
| Cash at end of period                                                              |   | $                                                                                                | 12,170 |                                   | $      | 9,899 |   | $ | 5,498 |   |
| **Noncash financing activities:**                                                  |   |                                                                                             |   |                                   |   |   |   |
| Deferred compensation related  to stock awards                                     |   | $                                                                                                | 3,695  |                                   | — |   | — |   |
| **Supplemental Cash Flow Information**                                             |   |                                                                                             |   |                                   |   |   |   |
| Cash paid during the period  for interest                                          |   | $                                                                                                | 6,640  |                                   | $      | 8,611 |   | $ | 8,320 |   |
| Cash paid during the period  for income taxes                                      |   | 1,950                                                                                            |   | —                                 |   | — |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F - 8

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**CAP ROCK ENERGY CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31, 2003, 2002, AND  2001**

 

**1.  SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

CapRock Energy Corporation, Inc. (the “Company” or the “Successor”) was formed inDecember 1998 in accordance with a conversion plan to reorganize a memberowned electric cooperative, Cap Rock Electric Cooperative, Inc. (the“Cooperative” or the “Predecessor”) to a shareholder owned businesscorporation.  The Cooperative wasincorporated as an electric cooperative in the State of Texas in 1939 toprovide electric distribution services and power to its members.  The Company currently provides service toapproximately 35,000 meters in 28 counties covering approximately 13,000 squaremiles in Texas.  Its customers, whichare principally residential, ranching and oil and gas, are located in theMidland-Stanton area of west Texas, the central Texas area around Brady, and innortheast Texas in Hunt, Collin and Fannin Counties.  The Company, through its subsidiaries, is also engaged in thetransmission of electricity through a looped system 305 miles in length, and inproviding various electric and nonelectric services to customers.

 

**Presentation and Principles of Consolidation**

 

Theaccompanying consolidated financial statements include the accounts of theCompany, Cap Rock Energy Corporation (“Energy”) and its wholly-ownedsubsidiaries, NewCorp Resources Electric Cooperative, Inc. (“NewCorp”), CapRock Cooperative Finance Corporation (“CRCFC”), Capstar Communications, PetraOne Energy, L.P., Petra Energy, LLC and the Cooperative.  The financial statements presented for theperiods ending on or before December 31, 2001, are the historicalconsolidated financial statements of the Cooperative, and the consolidatedfinancial statements for periods ending after January 1, 2002, are thoseof the Successor.  The Predecessor’sconsolidated financial statements include the accounts of the Cooperative andits wholly-owned subsidiaries, Energy, Capstar Resources, Inc.  (“Capstar”), Capstar Communications, Cap RockUtilities, Inc. (“Cap Rock Utilities”), New West Resources, Inc. (“New West”),CRCFC and NewCorp.  EffectiveJune 30, 2001, Capstar, Cap Rock Utilities and New West were dissolved andall remaining assets and liabilities were transferred to NewCorp.  The Cooperative was dissolved inMarch 2004.  Energy and NewCorpmaintain accounting records in accordance with the uniform system of accounts,as prescribed by the Federal Energy Regulatory Commission (“FERC”).

 

Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.  Unless otherwiseindicated, all references to the Company will include any and all activities ofits Predecessor.

 

**Use ofEstimates**

 

Thepreparation of the Company’s consolidated financial statements, in conformitywith generally accepted accounting principles, requires management to makeestimates and assumptions with respect to values or conditions which cannot beknown with certainty, that affect the recorded amounts of assets andliabilities, disclosure of contingent assets and liabilities and the recordedamounts of revenues and expenses. Actual results could differ from those estimates.  Items which may be estimated include, butare not limited to, the economic useful lives of assets, fair value of assetsand liabilities, impairment of goodwill, obligations under employee benefitplans, valuation allowances for receivables and deferred tax assets, unbilledrevenues for distribution services and electricity provided for which metershave not been read, and various other recorded or disclosed amounts.

 

**Regulatory Accounting**

 

TheCompany’s principal business is the transmission and distribution ofelectricity through NewCorp and Energy, respectively.  NewCorp is subject to regulation by the Federal Energy RegulatoryCommission, and Energy is now regulated by the Public Utility Commission ofTexas (“PUCT”).  Accordingly, theCompany accounts for the effects of regulation pursuant to SFAS No. 71,“Accounting for the Effects of Certain Types of Regulation.”  This statement applies to the financialstatements of an entity that has rates that (1) are approved by a bodyempowered to set rates that bind customers, (2)  are cost-based, and (3) can be charged to and

 

F - 9

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collectedfrom customers.  If an entity meets theabove three criteria, it is required to capitalize costs that would otherwisebe charged to expense if the actions of the regulating body make it probablethat those costs will be recovered through rates in future periods.  These capitalized costs are classified asregulatory assets.  SFAS No. 71 alsorequires the rate-regulated entity to assess the recoverability of regulatoryassets reflected on its balance sheet.

 

AtDecember 31, 2003, there were two regulatory liabilities, purchased powercost subject to refund, of $203,000, and $704,000 related to excess recovery ofcosts incurred in connection with the transfer of the Certificate ofConvenience and Necessity.  See alsoNote 23.  These are expected to berefunded to customers or earned within 12 months.  At December 31, 2002, the Company had one regulatory assetwhich was a purchased power cost recovery receivable of $3,501,000, and aregulatory liability which was deferred revenue of $2,182,000.  These items were recovered or recognizedwithin 12 months.

 

**Change in Year End**

 

Duringthe quarter ended December 31, 2001, the Board of Directors of theCooperative adopted a resolution changing the date of the Cooperative’s and itssubsidiaries’ fiscal year-end from March 31 to December 31, effectiveDecember 31, 2001. For comparative purposes, unaudited statements ofoperations for the year ended December 31, 2001, has been included for thePredecessor as shown in Note 4.

 

**Earnings PerShare**

 

Basicearnings per common share is computed by dividing net income by the weightedaverage number of common shares outstanding. Diluted earnings per common share is computed by dividing net income bythe weighted average number of common shares plus the dilutive impact of stockoptions, warrants and deferred compensation arrangements which were outstandingduring the period calculated by the treasury stock method.

 

**Pro Forma Earnings Per Share (Unaudited)**

 

Proforma basic and diluted earnings per share (unaudited) are presented in theaccompanying consolidated statement of operations for the nine months endedDecember 31, 2001. Pro-forma basic and diluted earnings per share arebased on the assumption that, on April 1, 2001, the Cooperative wasconverted from a member owned cooperative to a shareholder owned businesscorporation and 1,302,355 shares of common stock were issued for members’ownership interests.  As discussed inNote 2, such conversion occurred in February 2002.

 

**Cash and Cash Equivalents**

 

TheCompany considers all unrestricted highly liquid investments purchased withoriginal maturities of three months or less to be cash equivalents. Thecarrying amount of cash equivalents approximates market value due to theshort-term maturity of these investments.

 

**Restricted CashInvestment**

 

TheCompany is required to maintain a restricted cash investment of $14,169,000which serves as collateral for the initial advance from Beal Bank S.S.B.  Terms of the loan agreement provide forinvestment of the cash collateral only in certain specified types ofinvestments.  Interest earned is notrestricted, and is not classified as restricted.  See Note 13.

 

F - 10

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**Allowance for Doubtful Accounts**

 

TheCompany provides an allowance for doubtful accounts receivable that areestimated to be uncollectible based on historical trends for each rateclass.  As of December 31, 2003 and2002, the allowance for doubtful accounts was $78,000 and $50,000,respectively. Bad debt expense for the years ended December 31, 2003 and2002, and the nine months ended December 31, 2001, was $113,000, $120,000,and $102,000, respectively.

 

**Inventories**

 

Althoughthe Company has outsourced its materials warehousing function to an outsidethird party, inventories owned and on hand are primarily transmission parts andmaterials which are not normally stocked by the warehousing company; suppliesand materials maintained on service trucks; and materials at various remotefield locations.  Inventories are valuedat historical cost, at the lower of cost or market.

 

**Investments and Notes Receivable**

 

TheCompany accounts for its investments under the cost basis method of accountingif the investment is less than 20% of the voting stock of the investee, orunder the equity method of accounting if the investment is greater than 20% ofthe voting stock of the investee. Investments accounted for under the cost method are recorded at theirinitial cost, and any dividends or distributions received are recorded inincome.  For equity method investments,the Company records its share of earnings or losses of the investee during theperiod.  Recognition of losses will bediscontinued when the Company’s share of losses equals or exceeds its carryingamount of the investee plus any advances made or commitments to provideadditional financial support.

 

TheCompany has investments in associated organizations that relate primarily torequired membership certificates and accumulated capital allocations, all ofwhich are accounted for using the cost method of accounting.  Capital allocations for the two primaryinvestees, National Rural Utilities Cooperative Finance Corporation (“CFC”) andTexas Electric Cooperative, Inc. (“TEC”), are determined annually by therespective organizations based on its bylaws, operating margins, cash positionsand other factors.  The Companyrecognizes equity allocations from the respective organization as income whenit is declared by each respective organization.  CFC is the Company’s primary lender and TEC provides variouslobby services for electric cooperatives in Texas.

 

TheCompany previously had investments in oil and gas royalty interests.  As discussed in Note 8, effectiveDecember 1, 2000, the Company transferred its oil and gas royaltyinterests in exchange for shares of common stock of Map Resources, Inc. (“MAP”)and accounted for its investment in MAP under the equity method ofaccounting.  The MAP investment was soldOctober 2003.

 

**Utility Plant**

 

Utilityplant is stated at the original cost of construction, including the cost ofcontracted services, direct labor, materials and similar overhead items.  Contributions in aid of construction arecredited to the applicable utility plant accounts.  Gains or losses resulting from retirements or other dispositionsof utility property in the normal course of business are credited or charged tothe accumulated provision for depreciation. The cost of maintenance, repairs and minor replacements are charged tooperations as incurred.  The Companydoes not accrue any cost in advance for major maintenance or repair projects orthe cost of removal.

 

F - 11

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Depreciationis provided on a straight line basis over estimated useful lives of the assetsas follow:

 
| Transmission  plant         |   | 10 - 33 years |       |
|-----------------------------|--------|---------------|------------|
| Distribution  plant         |   | 32 years      |       |
| General  plant:             |   |          | ** ** |
| Structure  and improvements |   | 10-40 years   |       |
| Transportation              |   | 3 years       |       |
| Equipment                   |   | 3 years       |       |
| Other                       |   | 5-7 years     |       |

 

**Nonutility Property**

 

Nonutilityproperty is real estate, primarily an office building, and investments in realestate partnerships not principally used in the Company’s core business ofelectric distribution.  All nonutilityproperty except real estate partnerships is stated at original cost.Maintenance, repairs and miscellaneous replacements and renewals of this typeof nonutility property are charged to operations as incurred. The majority ofdepreciation is provided on a straight line basis over estimated useful lives,which range from 15 to 30 years.  Theinvestments in real estate partnerships are accounted for under the cost basismethod of accounting because the Company’s ownership is less than 10% in eachcase.

 

Incomeand expenses related to the Company’s primary real estate property arerecognized on an accrual basis. Income from the Company’s miscellaneous realestate partnership investments is recognized as income is received.

 

**Goodwill and Intangible Assets**

 

Goodwillis the excess of purchase price over the fair value of the net assetsacquired.  The Company adopted SFAS No.142, “Goodwill and Other Intangible Assets” effective January 1,2002.  Under SFAS No. 142, goodwill isreviewed annually for impairment or whenever events and changes incircumstances occur that may reduce the fair value below the carryingvalue.  Evaluation of fair value takesinto consideration various factors such as number of meters, economic growth ofa geographical area, diversity in the customer base and power suppliers andtheir mix of fuel costs.  No impairmenthas been necessary because the fair value of the recorded goodwill has exceededthe carrying value.  Prior to theCompany’s adoption of SFAS No. 142, goodwill was amortized on a straight-linebasis over 60 months.

 

Inconnection with the conversion of the line of credit with CFC into a long termmortgage note, the Company was required to pay a conversion fee.  This is being amortized over the life of thenew debt, which is 6 years.

 

TheCompany capitalized costs it incurred in connection with the financingarrangements with Beal Bank S.S.B.  Theterms of the initial advance with the bank provide for a due date ofSeptember 9, 2004, and because it is not certain that the Company willdraw on the additional advance, the financing costs are being amortized overthe 12 month period of the initial advance. See also Note 13.

 

TheCompany has other miscellaneous intangible assets that are not deemed to haveindefinite lives.  These assets willcontinue to be amortized over their estimated useful lives, which range from 3to 10 years.  See Note 11.

 

**Deferred Revenue**

 

Deferredrevenue is included in Deferred Credits on the balance sheet (see Note 17), andrepresented power costs expensed in prior periods that was billed to customersand recognized as revenue in subsequent periods.

 

F - 12

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**CapitalizedInterest**

 

TheCompany capitalizes interest cost to construction work in progress calculatedin accordance with SFAS No. 34, “Capitalization of Interest Cost.”

 

**Equities and Margins of the Cooperative**

 

TheCooperative’s equities and margins consisted of patronage capital credits,patronage capital obligated to be converted into shareholder equity, and otherequities and margin accounts for the periods before the conversion. Accordingto the Cooperative’s Bylaws, only the Cooperative’s operating profits could beallocated to the members’ equity accounts. Operating losses and nonoperatinggains and losses were recorded as other equities and margins and not allocatedto members’ equity accounts. Subsidiary gains and losses were recorded as otherequities and margins.

 

Forthe nine months ended December 31, 2001, in accordance with theCooperative’s conversion plan, the Cooperative repurchased certain members’equity account balances aggregating approximately $2,181,000, at a discountedcash price of $1,524,000. The difference was credited to the Cooperative’sother equity accounts. As of December 31, 2001, the equity retirementpayable had been fully paid.  As ofDecember 31, 2001, $12,390,000 was reclassified from Patronage Capital toPatronage Capital Obligated to be Converted into Shareholder Equity, with thesubsequent issuance of the Successor’s common stock in the first quarter of2002.

 

Forthe nine months ended December 31, 2001, in accordance with theCooperative’s conversion plan, the Cooperative repurchased certain members’patronage capital credit balances aggregating $909,000 by issuing electriccredits of the same respective amount to be ratably applied to the members’electric bills over a 24-month period. As of December 31, 2002 and 2001,the balance of the equity redemption credits was $732,000 and $1,195,000,respectively.

 

**Revenue Recognition**

 

Forall periods through December 31, 2002, the Company recorded revenue on thebasis of meters read and billed to customers. This was pursuant to the rate-making policy as set by the Company’sBoard of Directors.  The accrual methodrecognizes revenue when the service and power have been delivered to thecustomer.  Had the Company recordedrevenue on an accrual basis, a regulatory liability would have existed becauseit was not entitled to recognize revenue until the customers had beenbilled.  In the utility industry, therate-making policy defines the accounting requirements according to SFAS No.71.

 

Effective January 1,2003, the Company’s Board of Directors revised the rate-making policy torecognize unbilled revenue.  Therefore,the Company was required to change accounting principles.  Under the new rate-making structure, theCompany records revenue based on amounts billed to customers as well asunbilled amounts based upon an estimate of the revenues for energy and servicedelivered since the latest billing through the end of the period.  The effect of the change was to increaseelectric revenues by $3,400,000 and increase purchased power by $1,318,000, fora net increase in income before income taxes of $2,082,000.

 

Unrecognized,unbilled electric revenues as of December 31, 2002 and 2001, wereapproximately $2,521,000 and $2,076,000, respectively.

 

Otherrevenue consists primarily of building rental income and is accrued monthlybased on contractual lease obligations.

 

F - 13

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**Purchased Power Costs**

 

TheCompany accrues its purchased power cost based on actual usage through the endof each month.

 

TheCompany’s tariffs for electric service include power cost recovery clausesunder which electric rates charged to customers are adjusted to collect actualpurchased power costs incurred in providing service. In September 2001,the Company determined that approximately $1,700,000 of collected powerrecovery costs subject to refund represented billable costs to customers and asa result, recorded an adjustment to reduce purchased power costs and thepurchased power subject to refund account. This amount was reflected in thepower recovery costs subject to refund liability.  In January 2002, the Company determined that approximately$4,360,000, inclusive of the $1,700,000 described above, of power costsincurred and expensed in periods prior to 2002 were recoverable costs.  These costs were approved by the Board to berecovered through future billings to customers over a 24 month period beginningin January 2002 and ending in December 2003.  This created a regulatory asset, purchasedpower costs subject to recovery, and a regulatory liability, deferredrevenue.  See Note 17.

 

**Stock BasedCompensation**

 

EffectiveJanuary 1, 2003, the Company adopted the fair value method of accountingfor its employee stock incentive plan in accordance with SFAS No. 123,“Accounting for Stock-Based Compensation,” as amended by SFAS No. 148,“Accounting for Stock-Based Compensation, Transition and Disclosure.”  Under the historical or retroactivetransition method allowed by SFAS No. 148, the compensation expense for theyear ended December 31, 2002, would not have been different had the fairvalue method been originally applied. See also Note 16.

 

**Federal Income Taxes**

 

TheCompany accounts for federal income taxes under the asset and liability methodof accounting for income taxes.  Underthis method, deferred income taxes are recognized for the estimated future taxconsequences of “temporary differences” by applying enacted statutory tax ratesfor each taxable jurisdiction applicable to future years to differences betweenthe financial statement carrying amounts and the tax basis of existing assetsand liabilities.  The Company records avaluation allowance to reduce its deferred tax assets to the extent it is morelikely than not that such deferred tax assets will not be realized.  The effect on deferred tax assets andliabilities of a change in tax rate is recognized in income in the period thatincludes the enactment date.

 

TheCooperative and NewCorp are tax-exempt organizations under Internal RevenueCode Section 501(c)(12).  Uponconversion to a shareholder owned business corporation, the activities andtransactions formerly performed by the Cooperative became taxable.  Energy and Capstar are taxable organizationsfor Internal Revenue Service purposes and file a consolidated federal incometax return.  CRCFC is a taxableorganization for Internal Revenue Service purposes and files a separate federalincome tax return.

 

**Derivative Instruments**

 

TheCompany may use derivative instruments to manage the natural gas component ofpower costs, which minimize the fluctuations in customers’ power bills.  All payments made or received in connectionwith these types of transactions will be collected from or rebated to customersthrough the power cost recovery component of the customers’ power bills.  The fair market value of these instrumentsis recorded as an asset or liability with a corresponding regulatory liabilityor regulatory asset, as all amounts paid or received will be passed through tothe Company’s customers.  As of December31, 2003, no derivative portfolio was held.

 

F - 14

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**New Accounting Standards**

** **

**EffectiveJanuary 1, 2003, the Company adopted SFAS No. 143, “Asset RetirementObligations,”  which addresses thefinancial accounting and reporting for obligations associated with theretirement of tangible long-lived assets and the associated asset retirementcosts.  The implementation of thisstandard did not have a material impact on the Company’s financial position orresults of operations.**

** **

**SFAS No. 146,“Accounting for Costs Associated with Exit or Disposal Activities,” requiresthat a liability for costs associated with an exit or disposal activity berecognized and measured initially at fair value only when the liability isincurred.  SFAS No. 146 is effective forexit or disposal activities that are initiated after December 31, 2002,and was adopted by the Company effective January 1, 2003.  The implementation of this standard did nothave an impact on the Company’s financial position or results of operations.**

** **

**In November 2002, the FASB issued FASB InterpretationNo. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, including Indirect Guarantees of Indebtedness of Others” (“FIN45”). FIN 45 requires a guarantor to recognize a liability, at the inception ofthe guarantee, for the fair value of obligations it has undertaken in issuingthe guarantee and also include more detailed disclosures with respect toguarantees. FIN 45 is effective for guarantees issued or modified afterDecember 31, 2002 and requires the additional disclosures for interim orannual periods ended after December 15, 2002. See Note 14 concerning theCompany’s guarantee of debt.**

** **

**In January 2003, the FASB issued FASB InterpretationNo. 46, “Consolidation of Variable Interest Entities — an interpretation of ARBNo. 51” (“FIN 46”).  An additionalinterpretation, Interpretation No. 46R, was issued by the FASB inDecember 2003.  FIN 46 and 46Rrequire that if an entity has a controlling financial interest in a variableinterest entity, the assets, liabilities and results of activities of thevariable interest entity should be included in the consolidated financialstatements of the entity. FIN 46 requires that its provisions are effectiveimmediately for all arrangements entered into after January 31, 2003. Forthose arrangements entered into prior to January 31, 2003, the FIN 46provisions are required to be adopted at the beginning of the first interim orannual period beginning after June 15, 2003. The Company owns no interestsin variable interest entities, and therefore neither of these interpretationshas affected the Company’s consolidated financial statements.**

** **

**In December, 2002, the FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation, Transition and Disclosure,” (SFAS No.148) an amendment of FASB Statement No. 123. SFAS No. 148 amends FASB Statement No. 123, “Accounting for Stock-BasedCompensation” (SFAS No. 123), to provide alternative methods of transition fora voluntary change to the fair value based method of accounting for stock-basedemployee compensation.  In addition,SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method used on reported results. Effective January 1, 2003, the Company changed its method ofaccounting from the intrinsic method per APB Opinion No. 25, to the fair valuemethod per SFAS No. 148, and the impact of such change is not material.**

** **

**On April 22, 2003, the FASB announced its decision torequire all companies to expense the fair value of employee stock options.  Companies will be required to measure thecost according to the fair value of the options.  Although the new guidelines and ultimate measurement valuationmethodology have not yet been released, it is expected that they will befinalized soon and effective in 2004. When final rules are announced, the Company will assess the impact toits financial statements.**

 

F - 15

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**In April 2003, the FASB issued Statement No. 149(“SFAS No. 149”), “Amendment of Statement 133 on Derivative Instruments andHedging Activities.”  SFAS No. 149amends and clarifies financial accounting and reporting requirements forderivative instruments, including derivative instruments embedded in othercontracts, and for hedging activities under SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities.”  In general, SFAS No. 149 is effective for contracts entered intoor modified after June 30, 2003, and for hedging relationships designatedafter June 30, 2003.  Adoption ofthis statement did not have a material impact on the Company’s financialposition or results of operations.**

** **

**In May 2003, the FASB issued Statement No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity” (“SFAS No. 150”).  Thisstatement establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity.  This statement is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003.  Adoption ofSFAS No. 150 did not have a material impact on its financial statements.**

** **

**Other Comprehensive Income**

 

There were no items ofcomprehensive income for any period presented.

 

**Reclassifications**

 

Certainreclassifications have been made to prior periods’ financial statements toconform to the presentation adopted in the current period.

 

**2.  CORPORATE RESTRUCTURING**

 

OnOctober 20, 1998, the Cooperative’s members adopted a conversion plan toreorganize the Cooperative from a member owned electric cooperative to ashareholder owned business corporation. The conversion plan granted broadpowers to the Cooperative’s Board of Directors, without further action of themembership, to engage in all transactions necessary to implement the conversionplan. Such powers include, among other things, the ability to form andcapitalize new entities, transfer and/or sell assets, and purchase interests ofthe members and holders of the Cooperative’s equity accounts.

 

Inconnection with the conversion plan, Cap Rock Energy Corporation was formed inDecember 1998 as a subsidiary of the Cooperative and substantially all ofthe Cooperative’s operational activities were transferred to Energy. Under theconversion plan, the Cooperative was to continue in existence and was tocontinue to provide electricity to its members until such time as the Board ofDirectors, at its option and without further approval or action of its members,elected to take one of the actions authorized therein. The Board elected totransfer all of the assets and liabilities to Energy, in exchange for commonstock of Energy, to distribute such stock to the Cooperative’s members andholders of equity accounts and ultimately to liquidate and dissolve theCooperative.  The Cooperative wasdissolved in March 2004.

 

AllCooperative members with equity accounts greater than $10 received notices fromthe Cooperative regarding their equity account balances and the “Dutch auction”and electric credit process as outlined in the conversion plan.  The Cooperative accepted all Dutch auctionbids of 70% or less of stated capital credit account balances received frommembers. The difference between the stated capital credit account balances andthe discounted Dutch Auction cash price was credited to the Cooperative’s OtherEquity account.  As of December 31,2001, the equity retirement payable had been fully paid.  As of December 31, 2001, $12,390,000was reclassified from Patronage Capital to Patronage Capital Obligated to beConverted to Shareholder Equity, with the subsequent issuance of Energy commonstock in the first quarter of 2002.

 

F - 16

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Energyregistered shares of its common stock with the Securities and ExchangeCommission as of February 8, 2002, and they were distributed to theCooperative’s members and holders of equity accounts that chose that option. OnMarch 14, 2002, the common stock of Energy was approved for listing on theAmerican Stock Exchange. See Note 3 concerning the Company’s related repurchaseoffer.

 

ThoseCooperative members who opted to receive electric credits equal to 100% oftheir equity account balances received those credits ratably over a 24-monthperiod beginning October 2001.  Theunamortized balance of equity redemption credits at December 31, 2002, was$732,000, and at December 31, 2003, all credits had been applied tocustomer’s balances.

 

Energy’sArticles of Incorporation provide that any shareholder or affiliate of ashareholder holding in excess of 5% of Energy’s outstanding common stock willhave its voting rights for those shares in excess of 5% reduced to 1/100 pershare.

 

**3.  REPURCHASE OFFER**

 

Sharesof the Company’s common stock were originally distributed to certain formermembers of the Cooperative who elected to receive shares of stock as paymentfor their equity and membership interest in the Cooperative.  Pursuant to the conversion plan, the Companymade a commitment to purchase those shares, held continuously by the originalowners of record until the first anniversary of the distribution of the sharesat a price of $10 per share if the Company had sufficient cash available topurchase all shares tendered.  TheCompany’s original purchase commitment was only to those shareholders who werethe original holders of record, and who had held those shares continuouslyuntil the first anniversary of the distribution of the shares.  In an effort to be inclusive, rather thanexclusive, the Company made the offer to all shareholders and extended theoffering period beyond the original 60 days. The offering period began February 5, 2003, and ended April 30,2003, with 82,140 shares of common stock tendered to and accepted by theCompany at $10 per share, totaling $821,400. At December 31, 2003, such amount is shown in Treasury stock withinthe Stockholders’ Equity section of the consolidated balance sheet.  There are no further obligations related tothe Company’s repurchase commitment.

 

F - 17

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**4.**  **COMPARABLE STATEMENT OF OPERATIONS (UNAUDITED)**

 

The following unauditedcondensed consolidated statement of operations is presented in addition to the consolidatedstatements of operations in order to present comparable periods (in thousands):

 
|                           |   | **YEAR ENDED  DECEMBER 31,  2001** |   |
|--------------------------------|--------|-----------------------------------------|--------|
|                           |   | **Predecessor  (Unaudited)**            |   |
|                           |   |                                    |   |
| Total  operating revenues      |   | $                                       | 73,412 |   |
|                           |   |                                    |   |
| Purchased  power               |   | 40,781                                  |   |
| Operations  and maintenance    |   | 7,427                                   |   |
| General  and administrative    |   | 4,664                                   |   |
| Depreciation  and amortization |   | 6,159                                   |   |
| Property  taxes                |   | 1,380                                   |   |
| Other                          |   | 310                                     |   |
| Total  operating expenses      |   | 60,721                                  |   |
|                           |   |                                    |   |
| Operating  income              |   | 12,691                                  |   |
|                           |   |                                    |   |
| Interest  expense              |   | (10,818                                 | )      |
| Other  income items            |   | 2,961                                   |   |
| Net  income                    |   | $                                       | 4,834  |   |

 

**5. UNSUCCESSFUL LAMAR ACQUISITION**

 

InOctober 1999, the Cooperative entered into an agreement (“CombinationAgreement”) with Lamar County Electric Cooperative Association (“Lamar”),pursuant to which Lamar was to combine with, and become an operating divisionof, the Cooperative.  The members ofLamar subsequently approved this Combination Agreement.  The agreement provided that if thecombination was terminated by Lamar, with certain specific allowableexceptions, Lamar was required to reimburse the Cooperative for all costs andexpenses it had incurred, whether paid to outside parties or incurredinternally, with respect to the combination. The completion of the combination was delayed because of litigation withLamar’s power supplier. The power supplier claimed that Lamar and theCooperative had each breached various agreements.

 

OnAugust 29, 2000, the Cooperative and Lamar entered into a five yearManagement Service Agreement.  Under theterms of that agreement, Lamar’s Board of Directors continued to set policy andperform all of its fiduciary responsibilities, and the Cooperative performedcertain management services for Lamar. As compensation for its management services, the Cooperative(subsequently the Company) received $1,000 per month plus reimbursed costs andexpenses.  One of the terms of theagreement provided that if Lamar terminated the agreement prior to theexpiration of the original term, Lamar would be required to pay a cancellationfee of $300,000 as liquidated damages.

 

F - 18

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Lamar terminated theCombination Agreement in October 2002 and the Management Service Agreementin November 2002.  Lamar filed suitagainst the Company seeking a declaratory judgment that it had the right toterminate both agreements without regard to payment of any kind to theCompany.  The Company believes thatLamar’s stated reason for termination of the Combination Agreement does notfall within the specific allowable exceptions set forth in the agreement, andtherefore the Company believes it is entitled to reimbursement of all costs andexpenses incurred.  The Company is alsoseeking the specified liquidated damages fee of $300,000 in connection with thetermination of the Management Service Agreement.

 

BecauseLamar terminated the Combination Agreement, generally accepted accountingprinciples required the impairment of previously capitalized costs that wereincurred in connection with the combination. The majority of these costs were outside legal and consulting fees.  At December 31, 2002, these costs,aggregating  $1,357,000 were expensedand are shown on the consolidated statement of operations.

 

**6.  EARNINGS PER SHAREINFORMATION**

 

Thefollowing table shows the reconciliation of basic and diluted earnings pershare:

 
|                                                                  |   | **YEAR ENDED  DECEMBER 31, 2003** |   |
|-----------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                  |   | **Income**                             |   | **Shares** |   | **Per Share** |   |
|                                                                  |   | **(In Thousands)**                     |   |   |   |   |   |
| Basic  earnings per share:                                            |   |                                   |   |   |   |   |   |
| Income  from continuing operations available for common stock         |   | $                                      | 11,198 |   | 1,455,443 |   | $ | 7.69 |   |
|                                                                  |   |                                   |   |   |   |   |   |
| Effect  of diluted securities:                                        |   |                                   |   |   |   |   |   |
| Shares  that have been deferred under the Stock for Compensation plan |   |                                   |   | 55,298 |   |   |   |
|                                                                  |   |                                   |   |   |   |   |   |
| Diluted  earnings per share:                                          |   | $                                      | 11,198 |   | 1,510,741 |   | $ | 7.41 |   |

 

Bothbasic and diluted earnings per share for the year ended December 31, 2002,are not materially different. The proforma basic and diluted earnings per sharefor the nine months ended December 31, 2001, are the same.

 

**7.  OTHER CURRENTASSETS**

 

Other current assets as ofDecember 31, 2003 and 2002, consisted of the following (in thousands):

 
|                                  |   | **DECEMBER 31,** |         |     |   |
|---------------------------------------|--------|-----------------------|--------------|----------|--------|
|                                  |   | **2003**              |         | **2002** |   |   |   |
|                                  |   |                  |         |     |   |   |   |
| Capital lease sinking fund  (Note 13) |   | $                     |  — |     | $      | 7,395 |   |   |   |
| Inventories                           |   | 939                   |         | 930      |   |   |   |
| Prepaid insurance                     |   | 385                   |         | 335      |   |   |   |
| Interest receivable                   |   | 67                    |         | 58       |   |   |   |
| Other                                 |   | 196                   |         | 17       |   |   |   |
| Total Other Current Assets            |   | $                     | 1,587        |     | $      | 8,735 |   |   |   |

 

F - 19

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At December 31, 2002,the capital lease sinking fund balance of $7,395,000 is shown in Other CurrentAssets because the final balloon payment associated with the capital lease forthe transmission system was due in 2003. In prior periods, the balance of the capital lease sinking fund wasshown in Other Assets.

 

**8.  INVESTMENTS ANDNOTES RECEIVABLE**

 

Investmentsand notes receivable as of December 31, 2003 and 2002, consisted of thefollowing (in thousands):

 
|                                           |   | **DECEMBER 31,** |   |     |   |
|------------------------------------------------|--------|-----------------------|--------|----------|--------|
|                                           |   | **2003**              |   | **2002** |   |   |   |
| Investments in associated  organizations:      |   |                  |   |     |   |   |   |
| CFC capital term certificates                  |   | $                     | 6,210  |     | $      | 6,304 |   |   |   |
| CFC patronage capital                          |   | 2,543                 |   | 2,519    |   |   |   |
| TEC patronage capital and  bonds               |   | 852                   |   | 852      |   |   |   |
| Other                                          |   | 49                    |   | 73       |   |   |   |
| Total investments in  associated organizations |   | 9,654                 |   | 9,748    |   |   |   |
|                                           |   |                  |   |     |   |   |   |
| Investment in United Fuel  (Note 14)           |   | 360                   |   | 360      |   |   |   |
| Investment in MAP                              |   | —                |   | 2,162    |   |   |   |
| Other investments                              |   | 31                    |   | 220      |   |   |   |
| Total Investments and Notes  Receivable        |   | $                     | 10,045 |     | $      | 12,490 |   |   |   |

 

Allocationsof income from all associated organizations was $530,000, $478,000 and$1,205,000, respectively, for the years ended December 31, 2003 and 2002,and the nine months ended December 31, 2001.

 

TheCompany owned approximately 42% of MAP and accounted for its investment usingthe equity method.  EffectiveOctober 8, 2003, the Company reached an agreement with MAP to sell itsshares of stock in exchange for a note receivable of $1,250,000, dueOctober 8, 2004, with interest at 6% per annum.  The note receivable, shown in Current Notes Receivable, iscollateralized by the original stock. The investment appreciated over the period that the Company held it, butbecause the sales price was less than the recorded book value on an equitymethod basis, the Company was required to reflect a loss of $1,056,000.  Upon receipt of the proceeds from the notereceivable, the Company will have recouped its original cash investment.  The Company’s equity earnings in MAP for thenine month period ended September 30, 2003, the year endedDecember 31, 2002, and the nine months ended December 31, 2001, was$144,000, $115,000 and $88,000, respectively.

 

InMarch 2004, the Company signed an agreement with a shareholder of United Fuelto sell its shares of stock at a sales price of $1,300,000.  Consummation of the sale is contingent uponcertain future events, such as United Fuel’s capitalization arrangements.  It is unknown when those events willtranspire.

 

F - 20

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**9. UTILITY PLANT**

 

Utilityplant as of December 31, 2003 and 2002, consisted of the following (inthousands):

 
|                                 |   | **DECEMBER 31,** |    |     |    |
|--------------------------------------|--------|-----------------------|---------|----------|---------|
|                                 |   | **2003**              |    | **2002** |    |   |   |
|                                 |   |                  |    |     |    |   |   |
| Transmission facilities              |   | $                     | 69,051  |     | $       | 63,943 |   |   |   |
| Distribution facilities              |   | 179,250               |    | 177,678  |    |   |   |
| General facilities                   |   | 9,045                 |    | 10,456   |    |   |   |
| Total utility plant                  |   | 257,346               |    | 252,077  |    |   |   |
| Less accumulated depreciation        |   | (105,349              | )       | (95,785  | )  |   |   |
| Total utility plant in  service, net |   | 151,997               |    | 156,292  |    |   |   |
| Construction work in progress        |   | 165                   |    | 225      |    |   |   |
| Total Utility Plant, net             |   | $                     | 152,162 |     | $       | 156,517 |   |   |   |

 

Allutility plant assets are pledged to collateralize debt and capital leaseobligations.

 

**10.  NONUTILITYPROPERTY**

 

Nonutilityproperty as of December 31, 2003 and 2002, consisted of the following (inthousands):

 
|                           |   | **DECEMBER 31,** |   |     |    |
|--------------------------------|--------|-----------------------|--------|----------|---------|
|                           |   | **2003**              |   | **2002** |    |   |   |
|                           |   |                  |   |
| Real estate                    |   | $                     | 2,278  |     | $       | 2,257 |   |   |   |
| Furniture, fixtures, and other |   | 7                     |   | 7        |    |   |   |
| Total nonutility property      |   | 2,285                 |   | 2,264    |    |   |   |
| Less accumulated depreciation  |   | (740                  | )      | (700     | )  |   |   |
| Total Nonutility Property, net |   | $                     | 1,545  |     | $       | 1,564 |   |   |   |
|                                |        |                       |        |          |         |  |  |  |  |  |

 

TheCompany owns a 45,000 square foot office building that is used as its generalcorporate headquarters. The Company currently occupies approximately 35% of thebuilding and the remainder is leased to commercial tenants, subject to leasingterms ranging from monthly to 7 years. For the years ended December 31,2003 and 2002, and the nine months ended December 31, 2001, third partybuilding rental revenue was $258,000, $286,000, and $244,000, respectively.Building rental revenues, which are not material to the Company’s operations,for each of the next five years are expected to be approximately $250,000 peryear. As of December 31, 2003 and 2002, the net book value of the buildingand related property was $1,141,000 and $1,161,000, respectively, which is themajority of the nonutility property.

 

TheCompany sold its investments in real estate partnerships in February 2004,to an unrelated third party in exchange for a note receivable of $286,000 due2009, with an interest rate of 4.5% per annum. There was no gain or loss recorded on the sale.  The note is collateralized by thepartnership interests.  In prior years,the Company had guaranteed debt of some of the partnerships, with the maximumexposure of such guarantees aggregating $5,178,000 at December 31,2003.  The sale of the partnershipinterests also involved the transfer of those guarantees to the buyer.  Income for each period shown related to thereal estate partnerships has been less than $12,000.

 

F - 21

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**11.  OTHER ASSETS ANDDEFERRED CHARGES**

 

Otherassets as of December 31, 2003 and 2002, consisted of the following (inthousands):

 
|                                                           |   | **DECEMBER 31,** |         |
|----------------------------------------------------------------|--------|-----------------------|--------------|
|                                                           |   | **2003**              |         | **2002** |   |
| Capital lease acquisition  cost, net of amortization (Note 13) |   | $                     |  — |   | $ |  735 |   |
| McCulloch goodwill, net of  amortization                       |   | 199                   |         | 199 |   |
| Bank fees, net of amortization  (Notes 12 and 13)              |   | 846                   |         | — |   |
| Other                                                          |   | 145                   |         | 104 |   |
| Total Other Assets and  Deferred Charges                       |   | $                     | 1,190        |   | $ | 1,038 |   |

 

TheMcCulloch goodwill represents costs incurred in connection with the acquisitionof an electric cooperative in 1999, in the amount of $373,000.  As of December 31, 2003 and 2002, theaccumulated amortization was $174,000.

 

The bank fees are costsincurred in connection with the conversion of the line of credit to a mortgagenote, as well as the refinancing of the transmission system with Beal Bank,S.S.B.  Accumulated amortization atDecember 31, 2003, aggregated $363,000, with none recognized as ofDecember 31, 2002.  See also Notes12 and 13.

 

**12.  MORTGAGE NOTESAND LINE OF CREDIT**

 

TheCFC notes have been issued in conjunction with a Second Restated Mortgage andSecurity Agreement, dated October 24, 1995 (“Loan Agreement”).  Substantially all of the Company’sdistribution assets are collateralized in connection with the notes, which havematurity dates ranging from 2005 to 2035, with required quarterly payments ofprincipal and interest.  Under the LoanAgreement, the Company may elect to pay interest on a fixed or variableinterest rate basis, as defined. The existing long-term debt consists of seriesof loans from CFC that impose various restrictive covenants, including, amongother things, provisions that prohibit the incurrence or guaranty of othersecured indebtedness and requires the maintenance of a 1.35 debt servicecoverage ratio, as defined in the CFC Loan Agreements. In addition, the Companymay not make any cash distribution or any general cancellation or abatement ofcharges for electric energy or services to its customers if the ratio of equityto total assets is less than 20%.

 

Inconjunction with the conversion plan, CFC waived the 20% equity to total assetsratio requirement, consented to the distribution of cash and electric creditsto former members, waived the 1.35 debt service coverage ratio requirement, andnotified the Company that all existing CFC indebtedness may remain in placewith CFC after the conversion from a member owned cooperative to a shareholderowned corporation.

 

F - 22

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InDecember 2002, the Company elected to convert the interest rates on themajority of the mortgage notes from variable to fixed.  These lock-ins of interest rates were donefor one, two and three year periods. Substantially all of the CFC fixed rate notes are subject to interestrate repricing at the end of various periods, at the Company’s option.  Mortgage notes with CFC as ofDecember 31, 2003 and 2002, consisted of the following (in thousands):

 
|                                                                                                      |   | **DECEMBER 31,** |    |
|-----------------------------------------------------------------------------------------------------------|--------|-----------------------|---------|
|                                                                                                      |   | **2003**              |    | **2002** |   |
| Interest  at 3.35% at December 2002 and 2003, with interest repricing in  January 2004 and 2005 |   | $                     | 10,400  |   | $ | 11,525 |   |
| Interest  at 4.20% with interest repricing in January 2005                                           |   | 69,109                |    | 70,519 |   |
| Interest  at 4.70% with interest repricing in January 2006                                           |   | 34,128                |    | 35,189 |   |
| Interest  at 4.50% with interest repricing in January 2007                                           |   | 6,080                 |    | — |   |
| Interest  at 4.30%                                                                                        |   | 28,000                |    | 28,000 |   |
| Interest  at fixed rates:                                                                                 |   |                  |    |   |   |
| 6.50%                                                                                                     |   | —                |    | 6,188 |   |
| 7.00%                                                                                                     |   | 2                     |    | 3 |   |
|                                                                                                      |   | 147,719               |    | 151,424 |   |
| less  current maturities                                                                                  |   | (4,531                | )       | (3,680 | ) |
| Total  mortgage debt, net of current portion                                                              |   | $                     | 143,188 |   | $ | 147,744 |   |

 

InOctober 2002, CFC agreed to convert the Company’s line of credit,aggregating $28,000,000, to a long term mortgage note, collateralized bydistribution assets, with quarterly principal payments of approximately$233,000 based on a 30 year amortization schedule, a final balloon payment in 5years and deferral of the initial principal payment for one year from the dateof closing.  Interest is at 4.30% perannum and payments are due quarterly. There was also a fee of $210,000 associated with the conversion.

 

TheCompany has capitalized, as a part of utility plant, the cost of borrowed fundsused for financing construction. Capitalized interest for the years endedDecember 31, 2003 and 2002, and the nine months ended December 31,2001, was $7,000, $12,000, and $31,000, respectively. The rate used forinterest charged to construction is the Company’s effective borrowing rate.

 

Annualmaturities of the mortgage notes as of December 31, 2003, are as follows(in thousands):

 

| 2004                 |   | $      | 4,531   |   |
|----------------------|--------|--------|---------|--------|
| 2005                 |   | 8,330  |    |
| 2006                 |   | 4,586  |    |
| 2007                 |   | 4,721  |    |
| 2008                 |   | 28,430 |    |
| Thereafter           |   | 97,121 |    |
|                 |   |   |    |
| Total  mortgage debt |   | $      | 147,719 |   |

 

**13.  TRANSMISSIONSYSTEM FINANCING**

 

Inconnection with the original financing and construction of its transmissionline, the Company entered into agreements with Southwestern Public ServiceCompany (“SPS”), Metropolitan Life Insurance Company, and John Hancock LeasingCorporation. These agreements qualified as capital lease obligations withreversionary features and, as a result, the transmission line, substationassets and associated capital lease obligations were recorded on the Company’sconsolidated financial statements.

 

F - 23

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Theoriginal cost of the transmission facility and costs related to consummation ofthe lease agreements totaled $61,999,000, and were being recovered fromcustomers through power cost billings over a ten year period.  Consistent with this ratemaking treatment,the transmission facilities and capital lease obligation were being amortizedover the same ten year period, with that period ending September 30, 2003.The monthly lease payments included an amount for a sinking fund, which was tobe used to reduce the amount of the final balloon payment on the capitallease.  The final balloon payment of$14,076,000 was due September 2003.

 

Regularlyscheduled monthly principal payments on the transmission system capital leaseobligation for the nine months ended September 30, 2003, year endedDecember 31, 2002, and nine months ended December 31, 2001, wereapproximately $3,556,000, $5,047,000, and $3,577,000, respectively.  The corresponding amortization of propertyand equipment under the capital lease was credited to accumulated depreciationand amortization accounts for the transmission facilities consistent withratemaking treatment.

 

Intereston the capital lease obligations for the nine months ended September 30,2003, year ended December 31, 2002, and the nine months endedDecember 31, 2001, was approximately $847,000, $1,443,000, and $1,305,000,respectively, and is classified as purchased power cost consistent withratemaking treatment.

 

Thelease payments included an amount for a sinking fund, which was to be used toreduce the amount of the final debt payment. As of December 31, 2002 and2001, the balance of the sinking fund was $7,395,000 and $6,189,000,respectively. See Note 7.

 

NewCorpsubmitted an application to the Federal Energy Regulatory Commission inJuly 2003, seeking authorization to borrow $31,500,000 from Beal BankS.S.B. (“Beal Bank”).  FERC approval wasreceived in August 2003.  Thearrangement with Beal Bank was segregated into two advances.  The initial advance provided proceeds of$14,076,000 for payment of the balloon payment on the transmission systemcapital lease, plus interest of $93,000 for a total of $14,169,000. Theadditional advance of $17,331,000 provides for $5,500,000 for working capitaland cash reserves for operations and maintenance of the transmission system,purchase of transmission assets from Cap Rock Energy Corporation, repayment ofa loan to another subsidiary, as well as payment of all costs and expensesassociated with the new loan arrangement. The new financing would also allow NewCorp to make such system upgrades,improvements and expansions, as may be necessary.

 

Theinitial advance was completed in September 2003.  Simultaneously, the original lien on the transmission system wasreleased and the sinking fund of $8,207,000 was transferred to a restrictedsecurities account.  NewCorp added$5,962,000 to the restricted securities account to bring the total restrictedcash investment to $14,169,000, the amount of the initial advanceproceeds.  This restricted cashinvestment is the only asset collateralized by Beal Bank in connection with theinitial advance.  Terms of the loanagreement provide for investment of the cash collateral only in certainspecified types of investments.  Uponfunding of the additional advance, the restricted cash investment would bereleased, and the transmission system, receivables and other assets related tothe transmission system would be the collateral for the full loan.  The loan is non-recourse to Cap Rock Energy.

 

Intereston the Beal Bank loan is the greater of 10.75% per annum, or 7% plus theone-month LIBOR rate, payable monthly. The initial advance amount of $14,169,000 is due September 9, 2004,unless the additional advance is funded on or before that date, in which case,the entire principal amount would be payable monthly amortized over 15years.  Pursuant to the terms of thefinancing arrangement, prepayment of the initial advance is not allowed beforeits scheduled maturity date; prepayment of the additional advance would not beallowed for the first 24 months of the loan period, with a 1% fee if prepaymentwas made during months 25 through 48. The financing arrangement also provided for a commitment fee of 2% ofthe total loan amount, with $457,000 payable for the initial advance, and theremaining $173,000 payable for the additional advance.  Additional customary fees payable to BealBank were for reimbursement of expenses, attorneys fees, appraisals andconsulting, which at December 31, 2003, aggregated $999,000.  Maintenance of certain financial covenantswould be required upon funding of the additional advance, and the Company and

 

F - 24

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NewCorpare already in compliance with such future requirements.  The Company would be required to maintainconsolidated net worth of $5,000,000 and NewCorp would be required to maintaina ratio of net income plus interest, taxes, depreciation and amortization todebt service of at least 1.2 to 1.0 on a rolling quarter basis.

 

Inthe accompanying consolidated balance sheet at December 31, 2003, theinitial advance of $14,169,000 is shown in current liabilities because it isnot certain that the Company will draw on the additional advance from BealBank.  The Company has other availableoptions, which it may pursue, such as refinancing the debt with another lender,entering into a sale leaseback arrangement or selling the transmission system.  All of the options available to the Companyare contingent upon the transfer of NewCorp’s Certificate of Convenience andNecessity.  See Note 23, “Commitmentsand Contingencies.”

 

**14.  NOTE PAYABLE ANDOTHER CAPITAL LEASES**

 

InJuly, 2000, the Cooperative entered into and guaranteed, with CFC’s permission,a $15 million, three-year loan agreement with a bank. At December 31,2002, the bank loan balance was $12,490,000 and was shown entirely in Currentportion of long-term debt because it was due in 2003.  The loan agreement required monthly payments based on afifteen-year amortization with interest at Wall Street Journal prime rate plus1%, which, at December 31, 2002, was 5.25%.  Simultaneously, the Cooperative loaned $15 million to two fueland lubricant subsidiaries of United Fuel and Energy Corporation (“UnitedFuel”) with terms and conditions substantially identical to the bank loanagreement, interest at Wall Street Journal prime rate plus 1.25%, and securedby United Fuel’s stock and properties, as well as plant and equipment of theUnited Fuel subsidiaries. The Cooperative had pledged its security ascollateral for its bank loan agreement. At December 31, 2002, the UnitedFuel note receivable balance was $12,490,000, and was shown entirely in Currentportion of notes receivable because it was due in 2003.  At closing, the Cooperative acquired a 10%interest in United Fuel for $300,000, at a cost of $3,000 per share. InJanuary 2001, the Cooperative acquired an additional 5% interest in UnitedFuel from certain selling United Fuel shareholders for $60,000, at a cost of$1,200 per share. In addition, beginning January 1, 2002, as long asUnited Fuel is indebted to the Company or until January 1, 2010, whicheveris earlier, the Company had a right to acquire an additional 10% ownership inUnited Fuel, subject to certain parameters. The Company accounts for its investment in United Fuel using the costmethod of accounting. If the Company’s ownership in United Fuel were to exceed20%, it would be required to use the equity method of accounting.  See Note 8.

 

InOctober 2003, United Fuel consummated financing with a lender thatprovided for funds to partially pay down the Company’s note payable to a bank,with United Fuel taking the position as borrower on the Company’s note payableto a bank, thus extinguishing United Fuel’s note receivable to theCompany.  The Company is no longer aborrower and its involvement has been reduced to being a secondary guarantorfor United Fuel’s note of $3,500,000. FASB Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers,” requires the Company to record a guarantee obligation that is measuredat fair value.  The Company’scalculation of fair value included factors such as being a secondary guarantorand United Fuel’s assets collateralizing the note.  The Company has calculated its exposure and recorded a guaranteeobligation of $35,000 in October 2003. Upon United Fuel’s repayment of the note and the bank’s release of theguaranty, scheduled for October 2004, the Company will be able toeliminate the recorded obligation.

 

F - 25

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TheCompany has other miscellaneous capital leases for certain equipment used inoperations, with such equipment included in utility plant on the balancesheet.  Future minimum lease paymentsare as follows (in thousands):

 
| 2004                             |   | $   | 123    |   |
|----------------------------------|--------|-----|--------|--------|
| 2005                             |   | 110 |   |
| 2006                             |   | 57  |   |
| 2007                             |   | 18  |   |
| Total  capital lease obligations |   | $   | 308    |   |

 

**15.  ACCRUED AND OTHERCURRENT LIABILITIES**

 

Accruedand other current liabilities at December 31, 2003 and 2002, consisted ofthe following (in thousands):

 
|                                             |   | **DECEMBER 31,** |        |
|--------------------------------------------------|--------|-----------------------|-------------|
|                                             |   | **2003**              |        | **2002** |   |
| Accrued taxes                                    |   | $                     |  18    |   | $ |  227 |   |
| Accrued interest                                 |   | 520                   |        | 479 |   |
| Accrued payroll and employee  benefits (Note 16) |   | 1,670                 |        | 1,530 |   |
| Regulatory liability                             |   | 704                   |        | — |   |
| Customer deposits and  prepayments               |   | 760                   |        | 752 |   |
| Accrued other                                    |   | 230                   |        | 66 |   |
| Total Accrued and Other  Current Liabilities     |   | $                     |  3,902 |   | $ |  3,054 |   |

 

**16.  EMPLOYEE BENEFITPLANS**

 

**ExecutiveDeferred Compensation Plans**

 

Asof December 31, 2001, the Company had an Executive Deferred CompensationPlan whereby management, members of the Board of Directors and certain highlycompensated employees could defer a portion of their compensation pursuant tothe terms of the plan.  Monies investedthrough the plan could be withdrawn by the respective individuals at any time,subject to applicable tax laws.  As ofDecember 31, 2002, the plan was terminated and all amounts weredistributed to the respective individuals.

 

InNovember 2002, the Board approved a new Executive Deferred CompensationRetirement Plan with terms similar to the original plan.  The Company may also make contributions tothe plan on behalf of the individuals participating in the plan.  A participant is 100% vested in contributionshe may make to the plan, with Company contributions vesting at 10% per year forthe first four years, and 20% per year for the next three years.  The Compensation Committee of the Board ofDirectors administers the plan.  InMarch 2004, $16,000 was contributed to the plan, and such amount is shownas a liability on the consolidated balance sheet at December 31, 2003.

 

**Stock IncentivePlan**

 

TheCompany has adopted a Stock Incentive Plan that provides for the granting ofoptions to purchase common stock, awards of common stock, both restricted andunrestricted, and certain related rights to eligible officers, employees anddirectors of the Company.  The plan willcontinue in effect until December 31, 2013.  The Stock Incentive Plan provides for a maximum of 800,000 sharesof the Company’s common stock to be used in the granting of options and awardsof stock.  Shares of common stock usedto satisfy such awards will

 

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beacquired by the Plan either through open market purchases or through theissuance of additional common stock. For the years ended December 31, 2003 and 2002, the Companyrecorded compensation expense of $2,045,000 and $30,000, respectively, inconnection with these awards.  Theseshares have not been issued or distributed. See also Note 11.

 

**Employee StockPurchase Plan**

 

TheCompany has adopted an Employee Stock Purchase Plan (“ESPP”) that provides itsemployees with the opportunity to purchase shares of its common stock throughaccumulated payroll deductions.  It isthe Company’s intention to have the ESPP qualify as an employee Stock PurchasePlan under Section 423 of the Internal Revenue Code of 1986, as amended.  The Employee Stock Purchase Plan providesfor a maximum of 150,000 shares.  As ofDecember 31, 2003, the ESPP had not been fully implemented, and no shareshad been issued.

 

**Stock forCompensation Plan**

 

TheCompany has adopted a Stock for Compensation Plan (“SCP”) that provides a meansfor eligible employees and directors to receive shares of the Company’s commonstock or restricted share units in lieu of cash compensation.  The SCP provides for a maximum of 500,000shares of the Company’s common stock to be used in conjunction with thisplan.  For the years endedDecember 31, 2003, and 2002, cash bonuses of $6,000 and $367,000respectively had been earned by individuals, who then were awarded shares ofstock in lieu of the cash compensation. These shares have not yet been distributed to the applicableindividuals.

 

**Defined Contribution Plan**

 

TheCompany has a 401(k) plan for employees who meet certain eligibilityrequirements.  The plan permits aspecified percentage of an employee’s salary to be voluntarily contributed on apre-tax basis, with a Company matching feature.  Participants may contribute from four percent of eligibleearnings up to the maximum federal limit to various self-directed investmentfunds.  The plan provides for variouslevels of Company matching contributions depending upon the level of employeecontributions.  Company contributionsaggregated $527,000, $481,000, and $331,000 for the years endedDecember 31, 2003 and 2002, and the nine months ended December 31,2001.

 

**Other Postretirement Benefits**

 

TheCompany provides continued major medical and life insurance coverage to retiredemployees and their dependents.  Thecost to maintain such benefits for the years ended December 31, 2003 and2002, and the nine months ended December 31, 2001, totaled $399,000,$858,000, and $227,000, respectively.

 

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Thefunded status of the plan and the amounts recognized on the balance sheet as ofDecember 31, 2003 and 2002 are as follow (in thousands):

 
|                                                                                                |   | **DECEMBER 31,** |   |
|-----------------------------------------------------------------------------------------------------|--------|-----------------------|--------|
|                                                                                                |   | **2003**              |   | **2002** |   |
| Accumulated Postretirement  Benefit Obligation (APBO):                                              |   |                  |   |   |   |
| Actives not yet eligible                                                                            |   | $                     | 3,149  |   | $ | 1,985 |   |
| Actives fully eligible                                                                              |   | 1,352                 |   | 724 |   |
| Retirees and dependents                                                                             |   | 4,618                 |   | 4,854 |   |
| Total APBO                                                                                          |   | 9,119                 |   | 7,563 |   |
| Plan assets at fair value                                                                           |   | —                |   | — |   |
| Accrued postretirement benefit  liability                                                           |   | 9,119                 |   | 7,563 |   |
| Unrecognized loss from past  experience different from that assumed and from changes in assumptions |   | (5,611                | )      | (4,695 | ) |
| Accrued postretirement benefit  cost                                                                |   | $                     | 3,508  |   | $ | 2,868 |   |

 

Changesin the accrued postretirement benefit cost for the years endedDecember 31, 2003 and 2002, and the nine months ended December 31,2001, are as follows (in thousands):

 
|                              |   | **DECEMBER 31,** |   |
|-----------------------------------|--------|-----------------------|--------|
|                              |   | **2003**              |   | **2002** |   | **2001** |   |
| Balance,  beginning of period     |   | $                     | 2,868  |   | $ | 2,696 |   | $ | 2,629 |   |
| Net  periodic postretirement cost |   | 1,039                 |   | 858 |   | 356 |   |
| Contributions                     |   | (399                  | )      | (686 | ) | (289 | ) |
| Balance,  end of period           |   | $                     | 3,508  |   | $ | 2,868 |   | $ | 2,696 |   |

 

Netperiodic postretirement benefit costs for the years ended December 31,2003 and 2002, and the nine months ended December 31, 2001, are as follow(in thousands):

 
|                             |   | **DECEMBER 31,** |   |
|----------------------------------|--------|-----------------------|--------|
|                             |   | **2003**              |   | **2002** |   | **2001** |   |
| Service  cost                    |   | $                     | 206    |   | $ | 148 |   | $ | 128 |   |
| Interest  cost                   |   | 504                   |   | 471 |   | 228 |   |
| Amortization  of experience loss |   | 329                   |   | 239 |   | — |   |
|                             |   | $                     | 1,039  |   | $ | 858 |   | $ | 356 |   |

 

Theassumptions used in the calculation of the costs presented above were asfollows:

 
|           |   | **DECEMBER 31,** |   |
|----------------|--------|-----------------------|--------|
|           |   | **2003**              |   | **2002** |   | **2001** |   |
| Discount  rate |   | 6.00                  | %      | 7.00 | % | 7.25 | % |

 

Medical,prescription drugs and dental cost trend rates:  Beginning at 9% in 2004, grading downward by 1% per year to anultimate rate of 5% per year in 2008.

 

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Theassumed health care cost trends significantly affect the amounts reported forthe post retirement health care liability. A one percentage point change in assumed health care cost trend rateswould have the following effects for 2004 (in thousands):

 
|                                                      |   | **One Percentage  Point** |   |
|-----------------------------------------------------------|--------|---------------------------|--------|
|                                                      |   | **Increase**              |   | **Decrease** |   |
| Effect  on total of service cost and interest cost        |   | $                         | 124    |   | $ | (98 | ) |
| Effect  on accumulated post retirement benefit obligation |   | 1,309                     |   | (1,055 | ) |
|                                                           |        |                           |        |  |  |  |  |

 

Noreturn on plan assets was assumed in the calculation as the Company holds nospecified plan assets.

 

Thefollowing table provides estimates of future benefit payments, which reflectexpected future service, as applicable (in thousands):

 

| 2004      |   | $     | 484    |   |
|-----------|--------|-------|--------|--------|
| 2005      |   | 549   |   |
| 2006      |   | 563   |   |
| 2007      |   | 588   |   |
| 2008      |   | 585   |   |
| 2009-2013 |   | 3,103 |   |

 

**17. DEFERRED CREDITS**

 

Deferredcredits at December 31, 2003 and 2002, consisted of the following (inthousands):

 
|                                |   | **DECEMBER 31,** |   |
|-------------------------------------|--------|-----------------------|--------|
|                                |   | **2003**              |   | **2002** |   |
| Post  retirement benefits (Note 16) |   | $                     | 3,508  |   | $ | 2,868 |   |
| Deferred  executive compensation    |   | 44                    |   | 3 |   |
| Unclaimed  member capital credits   |   | 67                    |   | 68 |   |
| Deferred  revenue                   |   | —                |   | 2,182 |   |
| Other                               |   | 58                    |   | 73 |   |
| Total  Deferred Credits             |   | $                     | 3,677  |   | $ | 5,194 |   |

 

Deferredrevenue relates to purchased power cost expensed in prior years and not billedto customers.  Rates billed in priorperiods were Board approved rates. Purchased power from prior periods was not billed to customers until thetiming was approved by the Board. Effective January 2002, the Company recorded $4,364,000 in deferredrevenue and a corresponding increase to its purchased power cost recoveryreceived related to recoveries of purchased power costs approved by theBoard.  The deferred revenues were beingrecovered from customers on a monthly basis over a 24 month period fromJanuary 2002 to December 2003. During 2002, the Company billed and recognized $2,182,000 of deferredrevenue, with the balance of  $2,182,000recognized in 2003.

 

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**18. FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

Thefollowing table presents the carrying amounts and estimated fair values of theCompany’s financial instruments at December 31, 2003 and 2002.  SFAS No. 107 defines the fair value of afinancial instrument as the amount at which the instrument could be exchangedin a current transaction between willing parties (in thousands):

 
|                       |   | **DECEMBER 31,** |   |
|----------------------------|--------|-----------------------|--------|
|                       |   | **2003**              |   | **2002** |   |
|                       |   | **BOOK  VALUE**       |   | **FAIR  VALUE** |   | **BOOK  VALUE** |   | **FAIR  VALUE** |   |
| Cash                       |   | $                     | 12,170 |   | $ | 12,170 |   | $ | 9,899 |   | $ | 9,899 |   |
| Restricted cash investment |   | 14,169                |   | 14,169 |   | — |   | — |   |
| Notes receivable           |   | 1,250                 |   | 1,250 |   | 12,490 |   | 12,490 |   |
| Mortgage notes             |   | 147,719               |   | 147,719 |   | 151,424 |   | 151,424 |   |
| Short-term note payable    |   | 14,169                |   | 14,169 |   | — |   | — |   |
|                            |        |                       |        |  |  |  |  |  |  |  |  |  |  |

 

Thebook value of cash and the restricted cash investment approximated fair valuebecause of the short maturity of those instruments. The carrying values ofaccounts receivable and account payables included in the accompanyingconsolidated balance sheets approximated market value at December 31, 2003and 2002. As described in Note 13, the Company has both fixed rate and variablerate notes, but the fair value of the fixed rate mortgage notes are assumed tobe the same as the carrying value because the interest rates are reflective ofmarket rates.

 

**19. MAJOR CUSTOMERS AND SUPPLIERS**

 

Forthe years ended December 31, 2003 and 2002, and the nine months endedDecember 31, 2001, the Company and its subsidiaries had no customer thataccounted for more than 10% of operating revenues.

 

TheCompany has outsourced its materials warehousing function to an outside thirdparty.  The terms of the contractprovide that the third party maintain an adequate inventory level ofdistribution type components, with after hours staffing in case ofemergencies.  The Company has also outsourcedits meter reading function.  In theevent the contract with the third parties should not be renewed, the Companybelieves its operations would not be severely affected because new contractscould be secured at competitive rates and in a timely manner.  See also Note 23, Commitments andContingencies.

 

**20. ELECTRIC DEREGULATION AND CUSTOMER CHOICE**

 

OnMay 27, 1999, the Texas legislature passed a bill relating to the restructuringof the electric utility industry in Texas. The bill, among other things,provided for retail competition to begin on January 1, 2002. Municipallyowned utilities and cooperatives could elect, but were not required, to offerretail customer choice on or after January 1, 2002.  The Company met the definition of a“cooperative” under this legislation.  On June 22, 2003, theGovernor of the State of Texas signed Senate Bill 1280 into law which becameeffective September 1, 2003.  Thedefinition of “electric cooperative” under the Public Utility Regulatory Act(“PURA”) included a “successor to an electric cooperative created beforeJune 1, 1999, in accordance with a conversion plan approved by a vote ofthe electric cooperative, regardless of whether the successor later purchases,acquires, merges with or consolidates with, other electric cooperatives.”  SB 1280 amended the PURA to treat asuccessor to an electric cooperative as an investor owned utility.  This legislation also provided forestablishment of schedules and procedures by the Public Utility Commission ofTexas for such a successor that was not previously subject to regulation as aninvestor owned utility prior to September 1, 2003, in order to comply withthe requirements of

 

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deregulationand competition.  The Company’s ratesare now subject to regulation and approval by the PUCT, not the Company’s Boardof Directors.

 

Underthe new law, the PUCT will establish schedules and procedures for the Companyto comply with the requirements of competition.  Although management believes that House Bill 1642 concerningavailable customer choice shall occur no sooner than 2007 for the major servicearea in which the Company operates, the PUCT may issue an order to the Companyfor a required time frame that may be a later date, or a date sooner, than2007.  The Company believes the PUCTwill be reasonable in developing such schedules and procedures and that suchaction will not adversely affect the Company’s customers.

 

**21. RELATED PARTY ACTIVITY**

 

Oneof the compensation vehicles utilized by the Company is the Achievement BasedContract – Southwestern Public Service Company (“ABC-SPS”).  The ABC-SPS contract provides for totalcompensation of 2% of the annual savings derived from the SPS purchased powercontract as compared to the prior Texas Utilities purchased powercontract.  Two executive officers arethe only remaining participants in the ABC-SPS contract, which expired inOctober 2003.  For the years endedDecember 31, 2003 and 2002, and the nine months ended December 31, 2001,compensation attributable to the contract was $126,000, $156,000 and $48,000,respectively.

 

Anothercompensation arrangement is the Achievement Based Compensation Contract-Mergeror Acquisition with Other Electric Utilities (“ABC-Merger Contract”).  The terms of the ABC-Merger Contractprovided for compensation to the participants equal to 1.5% of the total assetsadded to the Company by merger or acquisition. Total assets added means those mergers or acquisitions of electric ortelephone cooperatives or municipal electric systems that require theassumption of debt and equity. Compensation under the ABC-Merger Contract is to be allocated 60% toparticipating executive officers, 10% to the general counsel and 30% todirectors and advisory directors.  TheABC-Merger Contract, amended in 2000, expires in August 2010.  No amounts have been paid or accrued underthe ABC-Merger Contract for the years ended December 31, 2003 and 2002,and the nine months ended December 31, 2001.

 

TheAchievement Based Compensation Agreement – Corporate Asset Non-CFC FinancingArrangements (“ABC-Power Transmission Contract”) is another compensationvehicle relating to corporate objectives. Total participant compensation will be 1.0% of the net profit or netcapital acquired by the Company in connection with the sale or leaseback of thetransmission system, if payment of the earned compensation is taken in the formof cash.  If the participant elects totake payment in the form of common stock of the Company, the individual will beawarded shares based on twice the calculated compensation.  Compensation attributable to the ABC-PowerTransmission Contract will be allocated 69% to the executive officers and 31%to be allocated to the directors and former directors.  No amounts have been paid or accrued underthe ABC-Power Transmission Contract.

 

**22.  OTHER SHAREHOLDER MATTERS**

 

TheCap Rock Energy Corporation Shareholders’ Trust (the “Trust”) was establishedby the Company in October 2002, on behalf of former members of theCooperative whose current addresses are unknown and would have received sharesof common stock in connection with the conversion of the Cooperative into theCompany.  The shared authority of thetwo Trustees of the Trust is to make distribution of stock to beneficial ownerswhen they have been located.  As ofDecember 31, 2003 and 2002, there were 340,738 and 344,171 shares ofstock, respectively, held beneficially by the Trust.  Other powers are limited to those granted in the Trust document,the Funding Agreement and the Share Option Agreement.

 

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TheTrust provides that in the case of a tender offer or other repurchase offer bythe Company for shares of the capital stock of the Company, the Trustees may,in their sole discretion and acting jointly in the best interest of thebeneficiaries of the Trust, sell all of the shares held in the Trust to theCompany at the highest cash price offered under the tender offer or otherrepurchase offer.  If the tender offerby the Company has a premium of 25% ormore, the Trustees shall sell all of the shares at the highest cash priceoffered.  In addition, the Trusteesshall not vote the shares in favor of a sale or pledge of assets of theCompany, nor for any change in the capital structure or powers of the Companyor in connection with a merger or dissolution, unless previously approved bythe Company’s Board of Directors.

 

TheFunding Agreement between the Trust and the Company provides that the Trusteesmay request funds from the Company to pay for compensation and expenses of theTrustees in connection with their duties and responsibilities as Trustees ofthe Trust.  In the event the Companyfails to fulfill its obligations under the Funding Agreement, the Trustees maysell such shares as are necessary for the Trust to pay such compensation andexpenses.  The Company transferred lessthan $1,000 to the Trust in 2003 and 2002 to pay for the Trustees’ costs andexpenses.

 

TheShare Option Agreement grants the Company the right to acquire all of theshares held by the Trust that would otherwise escheat to the State ofTexas.  The Trustees must notify theCompany of their intent to escheat such shares, and the Company then has theright to purchase those shares at the average market price for 30 trading daysbefore the Company exercises its right under the agreement.  Pursuant to state law, the shares arescheduled to be escheated to the State of Texas in 2005.

 

**23. COMMITMENTS AND CONTINGENCIES**

 

TheCompany has various obligations to make future payments under contractualobligations:

 
|                         |   | **2004**                                                                                                                                                                                                                        |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   | **Total** |   |
|------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|-----------|--------|
|                         |   | **— — — — — — — —  — — — — — — (Thousands of dollars) — — — — — — — — — — — — — —** |   |
| Operating  lease obligations |   | $                                                                                                                                                                                                                               | 314    |     | $      | 97       |   | $        | 79     |     | $      | 42             |   | $         | 27     |   | $ | 25 |   | $ | 584 |   |
| Purchase  obligations        |   | 2,314                                                                                                                                                                                                                           |   | 1,837    |   | 1,837    |   | 1,837    |   | 140      |   | 811            |   | 8,776     |   |
| Other  long term liabilities |   | 1,188                                                                                                                                                                                                                           |   | 1,253    |   | 641      |   | 659      |   | 622      |   | 3,128          |   | 7,491     |   |
|                              |        |                                                                                                                                                                                                                                 |        |          |        |          |        |          |        |          |        |                |        |           |        |  |  |  |  |  |  |  |

 

Operatingleases relate primarily to equipment. Purchase obligations include IT services and power contracts.  All of the Company’s power contracts arefirm, full requirements contracts. These types of contracts require the Company to purchase all of itspower needs from the seller, but do not mandate a minimum purchase amount.  The amounts included for each year are basicrequired transmission charges.

 

TheCompany has entered into an agreement with a third party to provide certaininformation technology related managed services including assessment of thecurrent IT environment and future needs; product selection; implementation offinancial and operational IT systems; hosting of the applications in a remoteenvironment; user and application support, as well as desktop support.  Beginning March 2004, ongoingmaintenance and support costs will be based on the number of meters and willapproximate $1,697,000 per year through 2007. These amounts are reflected in the above table under Purchaseobligations.  If a termination ofservices occurs before the end of the contract, except for materialnonperformance, the Company will be required to pay a termination fee on adecreasing sliding scale over the term of the contract.  The maximum amount for such termination feeis $1,414,000.

 

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TheCompany has a contract with the City of Farmersville, Texas, to provide powerto its customers and assume all related billing and collection functions.  Terms provide for a two year writtennotification for termination by either party. The Company is obligated to make payments to the City of Farmersville ona revenue sharing type basis.  The 2004and estimated 2005 annual payments are $626,000 and are reflected in the tableunder Other long term liabilities.

 

TheCompany purchases all of its electric power pursuant to long-term wholesaleelectric power contracts with Southwestern Public Service Company, LowerColorado River Authority (“LCRA”) and Garland Power and Light (“Garland”). SPS,LCRA and Garland contracts expire in 2013, 2016 and 2005, respectively, andaccount for approximately 74%, 14% and 12%, respectively, of the Company’selectric power purchases for 2003. The contracts for power cover kWh usage, kWdemand levels, transmission, scheduling and ancillary services along withenergy and fuel costs. The Company’s purchased power costs fluctuate primarilywith the price of the fuel and usage. Management believes that in the event thecontracts are terminated, the Company’s operations will not be severelyaffected as new contracts can be secured at competitive rates with otherelectric power providers.  However, allcosts associated with purchased power are passed through to the retailcustomer.

 

TheCompany’s west Texas divisions are supplied power through a contract with SPS.The SPS contract has no minimum kWh usage requirements, but does have minimumcharges for kW demand and transmission services. The Company must pay a minimumof 65% of the prior twelve months highest monthly kW demand usage multiplied bya fixed rate along with their pro-rata share of the fixed transmission costsbased on the Company’s prior twelve months usage as a percentage of all SPSusage. The SPS contract allows the Company to purchase all power needed.Energy, kW demand, ancillary services and scheduling charges are based on fixedfactors charged against usage. The Company also pays a pro-rata share of SPS’sFERC regulated transmission charges. Fuel costs paid to SPS are based on SPS’sactual cost of fuel used to generate electricity. The SPS contract expires inDecember 2013.

 

TheLCRA contract covers all power utilized by the central Texas division of theCompany and permits the Company to purchase 100% of the power needed to supplythe native load of the division. LCRA charges the Company fixed factors forenergy, kW demand and scheduling services applied to our usage. LCRA’stransmission charges are fixed monthly charges regulated by the ElectricReliability Council of Texas (“ERCOT”). Fuel costs paid to LCRA are theCompany’s pro-rata share of the amounts that LCRA actually pays for fuel togenerate electricity. The Company is required to purchase power from LCRA, buthas no minimum usage levels and only minimal penalties. The contract betweenLCRA and the Company expires in June 2016.

 

Garlandprovides all power supply requirements, including ancillary and schedulingservices, for the division in northeast Texas and the City ofFarmersville.  The Company is notrequired to purchase a minimum amount of capacity, and is billed solely onactual usage.  The price per kWh is at afixed rate and does not fluctuate with the price of gas or other fuels.

 

Variousmembers of ERCOT provide the northeast Texas division of the Company withtransmission services. The PUCT regulates the transmission rates that arecharged by the ERCOT members. The Company pays a fixed monthly fee based on theestimated usage submitted prior to the beginning of each year. There is nocontract with the individual ERCOT members. Taking power over the ERCOT networkrequires the Company to pay fees regulated by the PUCT. The annual charges touse the ERCOT transmission network cover the period from January 1 toDecember 31 of each year. Withdrawing from ERCOT and using othertransmission services relieves the user of further charges. Because the use ofthe network is governed by ERCOT and falls under the jurisdiction of the TexasPublic Utility Commission, a contract is not required with each ERCOT member.

 

TheCompany has outsourced its materials warehousing function to an outside thirdparty.  The terms of the contractprovide that the third party maintain an adequate level of inventory in orderthat the Company may meet its needs in a timely manner.  The exclusive contract was for an initialterm of 5 years, and has been extended and modified for another 5 years throughNovember 2006.  The terms of thecontract also provide for

 

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terminationat any time by either party with 90 days written notice.  Upon any final contract termination byeither party, the Company is required to purchase and pay for any inventoryheld by the third party at cost plus 10%. The estimated inventory value plus 10% is approximately $1,120,000 atDecember 31, 2003.

 

TheCompany has also outsourced its meter reading function.  The basic terms of the three year contractprovide for a fee per meter read, with the contract extended through 2005,unless either party gives 150 days written notice at any time.

 

Atthe time of the Company’s conversion from an electric cooperative to aninvestor owned electric utility, the Texas Public Utility Regulatory Actprovided that a successor to an electric cooperative, such as the Company,would be treated as a cooperative for regulatory purposes. This would haveallowed the Board of Directors of the Company to continue to set the rates thatit charges its customers. In September 2001, the Company and theCooperative filed an application to transfer the Cooperative’s Certificate ofConvenience and Necessity to the Company. The CCN allows the Cooperative and the Company to serve electriccustomers in certain territories within the State of Texas. Various intervenorschallenged this transfer and the Company’s right to treatment as a cooperativefor regulatory purposes under the PURA. Following a contested proceeding, thePublic Utility Commission of Texas approved the transfer of the CCN, effectiveSeptember 1, 2003.

 

However,during the 2003 legislative session, Senate Bill 1280 (“SB 1280”) was adoptedwhich amended the PURA so that the Company would be treated as an investorowned utility subject to regulation by the PUCT.  TheCompany’s rates are now subject to regulation and approval by the PUCT, ratherthan the Company’s Board of Directors. In accordance with this change in the PURA, the Company filed itselectric service tariffs with the PUCT on September 2, 2003. The PUCT iscurrently reviewing those tariffs.  Inaddition, the PUCT initiated an inquiry to determine the reasonableness of theCompany’s electric rates and required the Company to submit a standard ratefiling package.  The Company submittedthat rate filing package in late February 2004. The filing contained arequest for a rate increase for the Company’s various customer classes, aggregatingapproximately 14%.  The increase is intendedto cover increased costs of service related to, among other things, propertytaxes, computer and IT systems and costs associated with being a regulatedinvestor owned utility.  Several partieshave intervened in these proceedings requesting, among other things, that theCompany’s rates be decreased and that the Company be required to refund allmonies it previously collected pursuant to a regulatory surcharge authorized bythe Board of Directors during 2003.  TheCompany believes its rates are reasonable and that the requested rate increaseis appropriate based upon its cost of service and reasonable return on itsinvested assets.

 

TheCompany cannot determine what action the PUCT will take with respect to itscurrent rates or its requested rate increase.  The PUCT is required to rule on the raterequest within a specified number of days. The Company expects a final ruling in the fourth quarter of 2004.

 

In1999, legislature was adopted that provided for the restructuring of theelectric utility industry in the State of Texas. The legislation provided that,except for transmission and distribution services and for recovery of strandedcosts, electric services and the associated prices should be determined bycustomer choice and the normal forces of competition.

 

Thelegislative purpose was to create a competitive retail market by allowing eachretail electric customer to choose their provider of electricity and byencouraging competition. PURA treated municipally owned utilities and electriccooperatives differently from other utilities for retail competition. Investorowned electric utilities were required to allow retail competition in theirservice areas beginning January 1, 2002. Municipally owned utilities andelectric cooperatives are able to choose whether or not to opt into retailcompetition. Retail competition deals only with the provision of electricityand not distribution or transmission services. Electric cooperatives were notrequired to functionally unbundle their operating and business activities asinvestor owned utilities were required to do. Since, prior to the passage of SB 1280, the Company was treated as acooperative for regulatory purposes, it was not subject to these requirements.  SB 1280 requires the PUCT to establishschedules and procedures for the Company to comply with the requirements ofderegulation and

 

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competition,particularly the ability of retail electric customers to choose their energysupplier and the unbundling of its services. The PUCT has not yet established these procedures and schedules for theCompany.

 

AlthoughManagement believes that House Bill 1642 concerning available customer choiceshall occur no sooner than 2007 for the major service area in which the Companyoperates, the PUCT may issue an order to the Company for a required time framethat may be a later date, or a date sooner, than 2007.

 

**As a regulated electricutility the Company’s rates are now subject to approval by the PUCT. This mayaffect the Company’s ability to fully recover its costs and its ability to earna return on its assets which it believes is reasonable.  Further, because of the time required tofile and receive approval of rate changes, this could result in delays in theCompany’s recovery of costs.**Therefore, to recovercosts in excess of the costs included in retail rates, the Company would haveto make a rate filing with the PUCT, which could be denied in whole or in part.Any increase in costs over the costs recovered through rates would reduce ourearnings if not offset by sales or other cost reductions. Purchased power costs are passed directly through tocustomers which reduces the Company’s exposure to variations in its costs ofpower. Regulation will also increase the cost of doing business in order tocomply with the PUCT’s rules and regulations and to comply with the PUCT’s ratemaking practices. We cannot predict the impact these new regulatoryrequirements will have on the Company, or the costs of compliance.

** **

In October 1999, the Company entered into anagreement with Lamar Electric Cooperative Association (“Lamar”), pursuant towhich Lamar was to combine with, and become an operating division of, theCompany.  The members of Lamarsubsequently approved this Combination Agreement.  The agreement provided that if the combination was terminated byLamar, with certain exceptions, Lamar was required to reimburse the Cooperativefor all costs and expenses it had incurred, whether paid to outside parties orincurred internally, with respect to the combination.

 

The completion of the combination was delayed dueto litigation with Lamar’s power supplier, Rayburn Country ElectricCooperative, Inc.  Rayburn filed suitagainst Lamar and the Cooperative claiming that each had breached variousagreements.  Rayburn sought and receivedan injunction preventing the combination from going forward.  Lamar and the Cooperative also filedlawsuits against Rayburn.  The lawsuitsare still pending and some claims are currently on appeal.

 

On August 29, 2000, the Cooperative and Lamarentered into a five year Management Service Agreement.  Under the terms of that agreement, theCompany received $1,000 per month plus reimbursed costs and expenses.  One of the terms of the Management ServiceAgreement provided that if Lamar terminated the agreement prior to theexpiration of the original term, Lamar would be required to pay a cancellationfee of $300,000 as liquidated damages.

 

Lamar terminated theCombination Agreement in October 2002 and the Management ServicesAgreement in November 2002.  Lamarfiled suit against the Company in the 62nd District Court in LamarCounty, Texas, seeking a declaratory judgment that it had a right to terminateboth agreements without regard to payment of any kind to the Company.  The Company believes that Lamar’s statedreason for termination of the Combination Agreement does not fall within thespecific allowable exceptions set forth in the agreement, and therefore theCompany is seeking reimbursement of all costs and expenses incurred with regardto the attempted combination which amount to at least $1.4 million and thecancellation fee of $300,000.

 

NewCorp’spredecessor, NewCorp Resources, Inc. (“NCR”) was a Texas corporation.  In late 1996, NewCorp was formed and it wasthe sole shareholder of NCR.  At thattime, NCR owned the 305 mile transmissions system that serves the Company’sWest Texas divisions and it held the CCN for that transmission system.  NCR was dissolved in December 1996 andall of its assets, including the CCN, passed to NewCorp by operation of law.

 

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Accordingly,no proceeding was implemented at the PUCT to transfer the CCN.  As a part of the Company’s efforts torefinance the transmission system, NewCorp recently requested that the PUCTcorrect the name on the CCN to reflect NewCorp as the holder of the CCN.  The PUCT staff has recommended, and theAdministrative Law Judges ruled, that this matter be handled through anonadministrative proceeding.  TheCompany does not believe that a formal proceeding to transfer the CCN isnecessary, however it does not intend to appeal the ruling.  A protracted PUCT proceeding could delay theCompany’s efforts to refinance the transmission system.

 

TheCompany has been notified by the IRS that it intends to examine the federalincome tax return of the Cooperative for the year 2001.  Because the Cooperative is a nontaxableentity, and the Company believes it filed a proper return, management believesthat the outcome of the audit will not have a material effect on the Company’sfinancial position, results of operations or liquidity.

 

TheCompany is involved in various other litigation matters, none of which isexpected to have a material impact on the financial condition, operatingresults or liquidity of the Company.

 

**24.  INCOME TAXES**

 

TheCompany accounts for income taxes in accordance with SFAS No. 109 “Accountingfor Income Taxes,” which requires the recognition of a liability or an asset,net of a valuation allowance, for the deferred tax consequence of all temporarydifferences between the tax basis and the reported amounts of assets andliabilities, and for the future benefit of operating loss carryforwards.

 

Thefollowing is a reconciliation of income tax expense as shown in theconsolidated statement of operations for the years ended December 31, 2003and 2002 (in thousands):

 
|                                                        |   | **2003** |   | **2002** |   |
|-------------------------------------------------------------|--------|----------|--------|----------|--------|
| Income  tax expense calculated at the statutory rate of 34% |   | $        | 4,521  |     | $      | 3,125 |   |
| Income  from nontaxable entities                            |   | (978     | )      | (1,626   | )      |
| State  tax expense                                          |   | 219      |   | 132      |   |
| Increase  in operating and capital loss carryovers          |   | —   |   | (2,680   | )      |
| Change  in effective tax rate of operating loss carryovers  |   | —   |   | (295     | )      |
| Change  in valuation allowance                              |   | (1,643   | )      | 1,599    |   |
| Other                                                       |   | (21      | )      | 159      |   |
| Tax  expense                                                |   | $        | 2,098  |     | $      | 414 |   |

 

Thefollowing is an analysis of consolidated income tax expense for the years endedDecember 31, 2003 and 2002 (in thousands):

 
|         |   | **2003** |   | **2002** |   |
|--------------|--------|----------|--------|----------|--------|
| Current      |   | $        | 2,098  |     | $      | 414 |   |
| Deferred     |   | —   |   | —   |   |
| Tax  expense |   | $        | 2,098  |     | $      | 414 |   |

 

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Thetax effects of significant temporary differences and carryforwards atDecember 31, 2002, are as follows (in thousands):

 
|                                    |   | **2003** |       | **2002** |       |
|-----------------------------------------|--------|----------|------------|----------|------------|
| Net  deferred tax assets (liabilities): |   |     | ** ** |     | ** ** |
|                                    |   |     |       |     |       |
| Accrued expenses                        |   | $        | 1,758      |     | $          | 333 |   |
| Allowance for doubtful accounts         |   | 28       |       | 18       |       |
| Net operating loss carryforwards        |   | 7,057    |       | 7,057    |       |
| Capital loss carryforwards              |   | 2,765    |       | 2,849    |       |
| Total deferred tax assets               |   | 11,608   |       | $        | 10,257     |   |
|                                    |   |     |       |     |       |
| Deferred revenue                        |   | —   |       | (521     | )          |
| Property and equipment                  |   | (3,362   | )          | (19      | )          |
| Other                                   |   | (172     | )          | —   |       |
| Total deferred tax liabilities          |   | (3,534   | )          | (540     | )          |
|                                    |   |     |       |     |       |
| Valuation allowance                     |   | (8,074   | )          | (9,717   | )          |
| Net deferred tax asset (liability)      |   | $        | —     |     | $          | — |   |

 

Asof December 31, 2003, the Company has net operating loss carryforwards ofapproximately $19.1 million.  The netoperating loss carryforwards are scheduled to expire in 2008 through 2021.  The Company has benefited approximately $5million of net operating loss carryforwards because it believes it has taxplanning strategies available to realize the benefit of its tax losscarryforwards.  In addition to the netoperating loss carryforwards, as of December 31, 2003, the Company has acapital loss carryforward of approximately $7.5 million, which is scheduled toexpire in 2004.

 

Thoughthe Company itself is not under examination by the Internal Revenue Service,the Company was recently notified by the IRS that certain federal income taxreturns of its Predecessor, and of its Predecessor’s affiliates, are or will beexamined by the IRS.  Although thisprocess has just begun, and it is too early to tell its ultimate outcome, theCompany believes that the Predecessor and its affiliates have adequatelyprovided for any foreseeable outcome. Therefore, the Company does not anticipate any material impact to itsearnings and cash flow as a result of these matters.

 

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**25. SEGMENT INFORMATION**

 

TheCompany has adopted SFAS No. 131, “Disclosures about Segments of a BusinessEnterprise and Related Information.” Substantially all of the Company’soperations are conducted in Texas and involve the distribution and sale ofelectricity.

 

Businesssegment information as of and for the years ended December 31, 2003 and2002, and the nine months ended December 31, 2001, is as follows (inthousands):

 

|                           |   | **TOTAL** |   |
|--------------------------------|--------|-----------|--------|
| Operating  revenues            |   |      |   |
| December 31,  2003        |   | $         | 82,852 |   |
| December 31,  2002        |   | 74,637    |   |
| December 31,  2001        |   | 53,122    |   |
| Net  income                    |   |      |   |
| December 31,  2003        |   | 11,198    |   |
| December 31,  2002        |   | 8,776     |   |
| December 31,  2001        |   | 4,430     |   |
| Identifiable  assets           |   |      |   |
| December 31,  2003        |   | 202,989   |   |
| December 31,  2002        |   | 211,294   |   |
| December 31,  2001        |   | 214,459   |   |
| Capital  expenditures          |   |      |   |
| December 31,  2003        |   | 5,209     |   |
| December 31,  2002        |   | 1,517     |   |
| December 31,  2001        |   | 4,333     |   |
| Depreciation  and amortization |   |      |   |
| December 31,  2003        |   | 10,772    |   |
| December 31,  2002        |   | 9,253     |   |
| December 31,  2001        |   | 8,328     |   |
| Interest  expense, net         |   |      |   |
| December 31,  2003        |   | 6,979     |   |
| December 31,  2002        |   | 7,103     |   |
| December 31,  2001        |   | 8,004     |   |
|                                |        |           |        |  |

 

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**26.  QUARTERLYFINANCIAL DATA (UNAUDITED)**

 

Thefollowing table summarizes results for each of the four quarters in the yearsended December 31, 2003 and 2002 (in thousands except per share data):

 
|                                  |   | **QUARTER ENDED**  |   |
|---------------------------------------|--------|--------------------|--------|
|                                  |   | **MARCH 31,** |   | **JUNE 30,** |   | **SEPTEMBER 30,** |   | **DECEMBER 31,** |   |
|                                  |   |               |   |
| **Period ended December 2002**   |   |               |   |   |   |   |   |   |   |
| Total revenues                        |   | $                  | 18,119 |   | $ | 18,300 |   | $ | 20,774 |   | $ | 17,444 |   |
| Operating income                      |   | 4,226              |   | 2,509 |   | 5,584 |   | 2,354 |   |
| Net income before income taxes        |   | 2,782              |   | 925 |   | 4,468 |   | 1,015 |   |
| Income tax expense                    |   | —             |   | — |   | — |   | 414 |   |
| Basic and diluted earnings per  share |   | 2.14               |   | .71 |   | 3.43 |   | .46 |   |
|                                       |        |                    |        |  |  |  |  |  |  |  |  |  |  |  |

 
|                                |   | **QUARTER ENDED**  |   |
|-------------------------------------|--------|--------------------|--------|
|                                |   | **MARCH 31,** |   | **JUNE 30,** |   | **SEPTEMBER 30,** |   | **DECEMBER 31,** |   |
| **Period ended December 2003** |   |               |   |
| Total revenues            |   | $                  | 22,344 |   | $ | 19,250 |   | $ | 23,343 |   | $ | 17,915 |   |
| Operating income               |   | 5,180              |   | 4,628 |   | 6,747 |   | 3,314 |   |
| Net income before income taxes      |   | 3,760              |   | 3,283 |   | 4,718 |   | 1,535 |   |
| Income tax expense                  |   | 699                |   | 678 |   | 80 |   | 641 |   |
| Basic earnings per share            |   | 2.35               |   | 2.00 |   | 2.96 |   | .57 |   |
| Diluted earnings per share          |   | 2.25               |   | 1.92 |   | 2.86 |   | .55 |   |
|                                     |        |                    |        |  |  |  |  |  |  |  |  |  |  |

 

TheLamar combination costs of $1,357,000 were expensed during the quarter endedDecember 31, 2002.

 

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