**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20549**

 

**FORM 10-K/A**

**(AMENDMENTNO. 2)**

 

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

 

**o****  Transition Report Pursuant to Section 13 or15(d)of the Securities Exchange Act of 1934**

 

**FOR THEFISCAL YEAR ENDED DECEMBER 31, 2004**

 

**COMMISSION FILE NUMBER**

**0-32667**

 

**CAP ROCKENERGY 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 telephonenumber, including area code             **432-683-5422**

 

Securities registered pursuant 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 the Act:          **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 the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theAct).

 

Yes o    No ý

 

**THEAGGREGATE MARKET VALUE OF THE COMMON STOCK HELD BY NON-AFFILIATES OF THEREGISTRANT AS OF JUNE 30, 2004, WAS APPROXIMATELY $33,882,696 BASED ON THECLOSING PRICE OF $27.10 FOR THE COMMON STOCK ON THE AMERICAN STOCK EXCHANGE ASREPORTED BY THE WALL STREET JOURNAL.**

 

**THE NUMBEROF SHARES OF COMMON STOCK OUTSTANDING ON MARCH 21, 2005, WAS 1,625,798.**

**DOCUMENTSINCORPORATED BY REFERENCE**

 

 

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**Portions of the Registrant’s definitive ProxyStatement for the 2005 annual meeting of its shareholders, which will be filed**

**with the Commission not later than April 29, 2005, areincorporated by reference into Part III of this report.**

 

**PART I**

 

**ExplanatoryNote**

**Form10-K/A Amendment No. 2**

 

This Amendment No. 2 to annual report on Form 10-K/A (“Amendment No. 2”),is being filed to amend the Company’s annual report on Form 10-K for the yearended December 31, 2004, which was originally filed on March 29, 2005 (“OriginalForm 10-K”), as well as Amendment No. 1 which was filed on July 28, 2005 (“AmendmentNo. 1”).  Accordingly, pursuant to Rule12b-15 of the Securities Exchange Act of 1934, as amended, this Form 10-K/Acontains the complete text of Item 6, 7, 8 and 9(a) of Part II, and Item 15 ofPart IV, as amended, as well as certain currently dated certifications.  Unaffected items have not been repeated inthis AmendmentNo. 2.

 

On August 24, 2005, the Audit Committee of the Company concluded thatthe Company would make certain amended filings because it had identified atechnical tax issue related to the tax exempt status of one of the Company’ssubsidiaries.  The issue relates to theincome tax treatment of the subsidiary for financial reporting purposes.    The Company is restating its consolidatedfinancial statements for the year ended December 31, 2004, to treat thesubsidiary as a taxable entity for financial reporting purposes.  The Company has generated net operatinglosses in earlier periods that would be used to offset the taxable nature ofthe subsidiary.  Therefore, the use ofthe net operating losses earlier than expected may result in taxes payable thatare greater than originally disclosed.  Becauseof the complex nature of the issue, the Company is in the process of requestingguidance from the Internal Revenue Service regarding the taxable nature of theentity.

 

The adjustment to the consolidated statement of operations for the yearended December 31, 2004, is an increase in income tax expense of$1,908,000.  Adjustments to theconsolidated balance sheet as of December 31, 2004, consisted of theelimination of the net deferred tax asset of $3,285,000, the creation of a netdeferred tax liability of $1,275,000 and current income tax payable of$633,000, and the elimination of the valuation allowance for the deferred taxasset of $3,285,000.  See Note 2 to theaccompanying consolidated financial statements for a discussion of theadjustments.

 

This amendment does not reflect events occurring after the filing ofthe Original Form 10-K, which was filed March 29, 2005, nor Amendment No. 1,which was filed on July 28, 2005. Certain other items have been revised or added in response to commentsfrom the Securities and Exchange Commission.

 

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**PART II**

 

**ITEM6. SELECTED FINANCIAL DATA**

 

**SELECTED CONSOLIDATED FINANCIAL DATA**

 

The following table sets forth selected consolidated financialstatement information for the years ended December 31, 2004, 2003 and 2002,nine months ended December 31, 2001 and 2000, and the year ended March 31,2001.  The following selectedconsolidated financial data should be read in conjunction with Item 7, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andItem 8, “Financial Statements and Supplementary Data.”

 
| ** **                                                       | ** ** | **YEARS  ENDED DECEMBER 31,** | ** ** | **NINE  MONTHS ENDED  DECEMBER 31,** | ** ** | **YEAR  ENDED  MARCH 31,** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|----------------------------|------------|
| ** **                                                       | ** ** | **2004**                      | ** ** | **2003**                             | ** ** | **2002**                   | ** ** | **2001 (1)** | ** ** | **2000 (4)** | ** ** | **2001** | ** ** |
| ** **                                                       | ** ** | **(RESTATED)**                | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** ** | ** ** | **(UNAUDITED)** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **(Thousands  of dollars)**   | ** ** |
| **CONSOLIDATED  STATEMENTS OF OPERATIONS DATA:**                 | ** ** | ** **                    | ** ** |
| Operating revenues                                               |       | $                             | 82,624     |                                 | $          | 82,844                     |       | $ | 74,637 |   | $ | 53,122 |   | $ | 52,100 |   | $ | 72,465 |   |
| Operating expenses                                               |       | (72,405                       | )          | (61,875                              | )          | (58,307                    | )          | (43,142 | ) | (50,101 | ) | (68,144 | ) |
| Operating income                                                 |       | 10,219                        |       | 20,969                               |       | 16,330                     |       | 9,980 |   | 1,999 |   | 4,321 |   |
| Other income (expense) (2)                                       |       | (6,926                        | )          | (7,634                               | )          | (7,140                     | )          | (5,550 | ) | (5,915 | ) | (8,502 | ) |
| Income (loss) before income taxes                                |       | 3,293                         |       | 13,335                               |       | 9,190                      |       | 4,430 |   | 3,916 |   | (4,181 | ) |
| Income tax (expense) benefit (3)                                 |       | 232                           |       | (2,137                               | )          | (414                       | )          | — |   | — |   | — |   |
| Net income (loss)                                                |       | $                             | 3,525      |                                 | $          | 11,198                     |       | $ | 8,776 |   | $ | 4,430 |   | $ | (3,916 | ) | $ | (4,181 | ) |
|                                                             |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
| **NET INCOME PER COMMON SHARE:**                                 |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
|                                                             |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
| Basic                                                            |       | $                             | 2.28       |                                 | $          | 7.69                       |       | $ | 6.74 |   |   |   |   |   |   |   |
| Diluted                                                          |       | $                             | 2.21       |                                 | $          | 7.41                       |       | $ | 6.74 |   |   |   |   |   |   |   |
|                                                             |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
| **WEIGHTED AVERAGE NUMBER OF COMMON SHARES  OUTSTANDING:**       |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
|                                                             |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
| Basic                                                            |       | 1,546,271                     |       | 1,455,443                            |       | 1,302,355                  |       |   |   |   |   |   |   |
| Diluted                                                          |       | 1,596,796                     |       | 1,510,741                            |       | 1,302,355                  |       |   |   |   |   |   |   |
|                                                             |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
| **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 |   |
|                                                             |       |                          |       |                                 |       |                       |       |   |   |   |   |   |   |
| ** **                                                       | ** ** | **DECEMBER  31,**             | ** ** | **MARCH 31,**                        | ** ** |
| ** **                                                       | ** ** | **2004**                      | ** ** | **2003**                             | ** ** | **2002**                   | ** ** | **2001 (2)** | ** ** | **2000 (4)** | ** ** | **2001** | ** ** |
| ** **                                                       | ** ** | **(RESTATED)**                | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** ** | ** ** | **(UNAUDITED)** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **(Thousands  of dollars)**   | ** ** |
| **CONSOLIDATED BALANCE SHEET DATA:**                             | ** ** | ** **                    | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Utility plant                                                    |       | $                             | 149,361    |                                 | $          | 152,162                    |       | $ | 156,517 |   | $ | 164,547 |   | $ | 170,111 |   | $ | 168,920 |   |
| Total assets                                                     |       | 199,687                       |       | 202,989                              |       | 211,294                    |       | 214,459 |   | 218,382 |   | 221,195 |   |
| Long-term debt, net                                              |       | 134,032                       |       | 143,372                              |       | 148,052                    |       | 181,732 |   | 184,688 |   | 188,627 |   |
| Equity and margins                                               |       |                          |       |                                 |       |                       |       | 7,672 |   | 6,012 |   | 5,675 |   |
| Stockholders’ equity                                        |       | 33,444                        |       | 26,973                               |       | 14,738                     |       |   |   |   |   |   |   |

 

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(1)           The Company changed its year-end from March31 to December 31, effective December 31, 2001.

(2)           Includes $1,357,000 of impaired costs relatedto the Lamar Combination for the year ended December 31, 2002.  See Note 5 to the consolidated financialstatements.

(3)           Upon conversion to a shareholder ownedcorporation, the activities and transactions of the parent became taxable.

(4)           This selected financial data is provided forinformational purposes only.  Thesenumbers are unaudited and are provided for a consistent presentation based on(1) above.

 

The selected financial datahas been restated to reflect the effects of a technical tax issue related tothe tax exempt status of one of the Company’s subsidiaries.  See Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” and Item 8, “FinancialStatements and Supplementary Data.”

 

**ITEM 7.    MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Cautionary Statement RegardingForward-Looking Statements**

 

Certain written and oral statements made by our Company or with theapproval of an authorized executive officer of our Company may constitute “forward-lookingstatements” as defined under the Private Securities Litigation Reform Act of1995, including statements set forth in this Form 10-K as they relate toManagement’s future plans and objectives, and in other filings with theSecurities and Exchange Commission. Generally the words “may,” “will,” “expect,” ‘intend,” “project,” “estimate,”“anticipate,” “believe,” or “continue” or the negative thereof and similarterminology identify forward-looking statements, which generally are nothistorical in nature.

 

All statements other than statements of historical facts included inthis report, including, without limitation, statements regarding the Company’sfuture financial position, business strategy, budgets, growth, sales projectedcosts and plans and objectives of Management for future operations, areforward-looking statements.  Forward-looking statements are subject to certain risks anduncertainties that could cause actual results to differ materially from ourCompany’s historical experience and our present expectations orprojections.  As and when made,management believes that these forward-looking statements are reasonable.  However, caution should be taken not to placeundue reliance on any such forward-looking statements since such statementsspeak only as of the date when made. There can be no assurances that any of these expectations will provecorrect or that any of the actions that are planned will be taken.  The Company undertakes no obligation topublicly update or revise any forward-looking statements, whether as a resultof new information, future events or otherwise.

 

The following are some of the factors that could cause our Company’sactual results to differ materially from the Company expectations described inor underlying our Company’s forward-looking statements:

 

•                  Weather conditions could affect ourelectricity sales and revenues;

•                  Changein rate structure and ability to earn a fair return on our rate base andrecover the costs of operations could affect our operations.  A negative outcome in our current rateproceeding could affect our Company’s profits;

•                  Federaland state regulatory actions, and associated legal and administrativeproceedings, especially as they relate to the oversight authority of the PublicUtility Commission of Texas could affect revenues and earnings and could causeus to lose customers through Increased competition in the electric utilityindustry;

•                  Demandsfor electric power and the associated costs, including changes in the costs ofpower plant fuels such as natural gas and coal could cause our purchased powercost to increase, which could in turn affect our customers’ usage and ourrevenues;

•                  Changesin the Company’s cash position and availability of capital resources;

•                  Theimpact of changes in interest rates;

 

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•                  Changesin federal and state tax laws;

•                  Unexpectedchanges in operating expenses and capital expenditures.

 

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

 

The following discussion and analysis of the Company and itsPredecessor’s financial condition and results of operations for the years endedDecember 31, 2004, 2003, and 2002, should be read in conjunction with the Company’saudited consolidated financial statements and related notes to financialstatements included elsewhere in this document. Unless otherwise indicated, all references to the Company will includeany and all activities of its Predecessor.

 

**Restatement**

 

On August 24, 2005, the Audit Committee of the Company concluded thatthe Company would amend the Annual Report on Form 10-K for the year endedDecember 31, 2004, because of a technical tax issue related to the tax exemptstatus of one of the Company’s subsidiaries.  The Company is restating its consolidated financial statements for theyear ended December 31, 2004, to treat the subsidiary as a taxable entity forfinancial reporting purposes.  TheCompany has generated net operating losses in earlier periods that would beused to offset the taxable nature of the subsidiary.  Therefore, the use of the net operatinglosses earlier than expected may result in taxes payable that are greater thanoriginally disclosed.  Because of thecomplex nature of the issue, the Company is in the process of requestingguidance from the Internal Revenue Service regarding the taxable nature of theentity.  In addition, it is uncertain atthis time whether the additional tax expense is recoverable from ratepayers,and as such has been expensed in the accompanying consolidated financialstatements.  See Note 2 to theaccompanying consolidated financial statements for a discussion of theadjustments.

 

Restated amounts as of and for the years ended December 31, 2004, 2003and 2002, are as follows:

 

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| ** **                                                               | ** ** | **As  Reported**                             | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                               | ** ** | **(In  thousands except per share amounts)** | ** ** |
| ** **                                                               | ** ** | ** **                                   | ** ** |
| **As of  and for the year ended December 31, 2004:**                     |       |                                         |       |            |       |             |       |
| Balance  sheet:                                                          |       |                                         |       |            |       |             |       |
| Net deferred tax asset                                                   |       | $                                            | 3,285      |            | $          | (3,285           | )          | $ | — |   |
| Valuation allowance for deferred tax asset                               |       | (3,285                                       | )          | 3,285           |       | —           |       |
| Current income tax payable                                               |       | —                                       |       | 633             |       | 633              |       |
| Net deferred tax liability                                               |       | —                                       |       | 1,275           |       | 1,275            |       |
| Statement of  operations:                                                |       |                                         |       |            |       |             |       |
| Income tax expense (benefit)                                             |       | (2,140                                       | )          | 1,908           |       | (232             | )          |
| Net income                                                               |       | 5,433                                        |       | (1,908          | )          | 3,525            |       |
| Net income  per common share:                                            |       |                                         |       |            |       |             |       |
| Basic                                                                    |       | 3.51                                         |       | (1.23           | )          | 2.28             |       |
| Diluted                                                                  |       | 3.40                                         |       | (1.19           | )          | 2.21             |       |
| Statement of  cash flows:                                                |       |                                         |       |            |       |             |       |
| Net cash provided by operating activities Other  assets/deferred credits |       | 1,617                                        |       | 1,275           |       | 2,892            |       |
| Income tax receivable                                                    |       | (3,986                                       | )          | 633             |       | (3,353           | )          |
| Net cash flows used in investing activities                              |       | (4,006                                       | )          | —          |       | (4,006           | )          |
| Net cash flows used in financing activities                              |       | (8,544                                       | )          | —          |       | (8,544           | )          |
|                                                                     |       |                                         |       |            |       |             |       |
| **As of and  for the year ended December 31, 2003**                      |       |                                         |       |            |       |             |       |
| Balance  sheet:                                                          |       |                                         |       |            |       |             |       |
| Deferred tax asset                                                       |       | 8,074                                        |       | (2,834          | )(a)       | 5,240            |       |
| Valuation allowance for deferred tax asset                               |       | (8,074                                       | )          | 2,834           | (a)        | (5,240           | )          |
|                                                                     |       |                                         |       |            |       |             |       |
| **As of  and for the year ended December 31, 2002**                      |       |                                         |       |            |       |             |       |
| Balance  sheet:                                                          |       |                                         |       |            |       |             |       |
| Deferred tax asset                                                       |       | 9,717                                        |       | (1,064          | )          | 8,653            |       |
| Valuation allowance for deferred tax asset                               |       | (9,717                                       | )          | 1,064           |       | (8,653           | )          |
|                                                                          |            |                                              |            |                 |            |                  |            |  |  |  |

 

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(a)          No net change to the statement of operations.

 

**Overview**

 

Cap Rock Energy Corporation is an electric distribution companyoperating in various noncontiguous areas in the State of Texas. The Companyprovides service to over 33,500 meters in 28 counties covering approximately13,000 square miles in Texas. This includes 23,000 meters within two operatingdivisions in the Midland-Stanton area of west Texas, 6,200 meters in thecentral Texas area around Brady, and over 4,300 meters in northeast Texas inHunt, Collin and Fannin Counties. The Company also provides management servicesto the Farmersville Municipal Electric System which services nearly 1,500meters in Farmersville, Texas.

 

The Company purchases power from wholesale suppliers and distributesthat power to its retail customers over transmission lines covering over 305miles and then over 11,000 miles of distribution lines. The Company’s primaryfocus is on the distribution of electricity to its customers, and therefore hasnot and does not plan to engage in the generation of electricity.  In 2003, the Company purchased all electricpower pursuant to wholesale electric power contracts with three suppliers.  Generally, the wholesale electric powersupply contracts are based on fixed charges for kWh usage, transportation andauxiliary services and a variable charge for fuel based on kWh usage. The Company’spurchased power costs fluctuate primarily with the price of fuel used togenerate that electricity, which is primarily natural gas and coal. However,all costs associated with purchased power are passed through to the retailcustomer.

 

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Effective September 1, 2003, the Company became subject to theoversight authority of the PUCT, and the rates and fees charged to customers bythe Company are now subject to PUCT approval. In accordance with this change, the Company filed its tariff forelectric service with the PUCT.  TheCompany was also required to submit a standard rate filing package to the PUCTin late February 2004, in connection an inquiry instituted by the PUCT todetermine the reasonableness of the Company’s electric rates.  This filing contained a request for a rateincrease for some customer classes.  Ahearing was held in October 2004 regarding the Company’s rate filing packageand a final decision is expected in the second quarter of 2005.  A hearing will be held in April 2005, todetermine if the tariffs filed by the Company are the actual tariffs that wereapproved by the Company’s Board of Directors, which was the Company’s previousregulatory authority.  The Companybelieves the issue is moot because any current tariff will be superseded by thetariff that is ultimately approved by the PUCT in the current rate case.  A total of $3,593,000 in third party costswere incurred to prepare the rate filing package, as well as the public hearingprocess.  The amount and period overwhich the Company will be allowed to recover these costs will be determined bythe PUCT.

 

At September 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 Fuel consummatedfinancing with a lender that provided for funds to partially pay down theCompany’s note payable to a bank, with United Fuel taking the position asborrower on the Company’s note payable to a bank, thus extinguishing UnitedFuel’s note receivable to the Company. The Company was a secondary guarantor for United Fuel’s note, and wasrequired to record a guarantee obligation based on fair value.  When United Fuel repaid the note to the bankin November 2004, the Company’s obligation as guarantor was effectivelyreleased and it was able to eliminate the recorded $35,000 guarantorobligation.

 

In March 2004, the Company signed an agreement with a shareholder ofUnited Fuel to sell the Company’s shares of stock in United Fuel at a salesprice of $1,300,000, in exchange for a note receivable from thatshareholder.  The terms of the agreementprovide for repayment after United Fuel has completed certain capitalizationarrangements.  All conditions requiredpursuant to the agreement have been satisfied, and the Company expects paymentas scheduled in 2005.  Recognition of thegain of $940,000 has been deferred until principal payments have been received.

 

The financing arrangements with Beal Bank provided for an initial andan additional advance.  The Company drewthe initial advance in September 2003.  Acollateralized cash investment was used to repay the initial advance of$14,169,000 in November 2004.

 

**Critical Accounting Policies and Estimates**

 

The Company’s significant accounting policies are described in Note 1to the consolidated 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 criticalfinancial estimates with the Board of Directors’ Audit Committee.

 

***Rate Regulation. ***The Company’s most critical accounting policy involves rateregulation.  The Company is subject tothe provisions of Statement of Financial Accounting Standards (“SFAS”)Statement No. 71, “Accounting for the Effects of Certain Types of Regulation.”  In certain circumstances, SFAS No. 71requires that certain costs and/or obligations be deferred on the balance sheetuntil matching revenues are recognized,

 

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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 immediately against income 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 customers, divided by the numberof kilowatt hours billed during the period. Power purchased includes transmission costs and wheeling charges.  This factor is estimated each month torecover actual power costs and is added as a surcharge to the base rate.  The factor is based on estimates of powercost increases or decreases due to changes in fuel cost, usage and other costfluctuations.  The estimate is adjustedin the subsequent month as compared to actual activity.  The Company currently defers the differencebetween actual purchased cost and billed cost as a regulatory asset or liability.  The regulatory asset or liability, as well asthe deferral, are adjusted accordingly by either receipt from, or refund to,the customer of the net deferred amount.

 

***Derivative Instruments and HedgingActivities.**** *The Company may enter 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.  Derivativetransactions minimize the fluctuations in the Company’s customers’ powerbills.  These instruments are measured atfair market value and recorded as an asset or liability with a correspondingregulatory asset or liability.  Changesin the fair value are recognized in current earnings unless specific hedgeaccounting criteria are met.    As ofDecember 31, 2004 and 2003, no derivative positions were 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 method recognizesrevenue on an “as billed basis” when the customer is billed and not on anaccrual basis, which recognized revenue as the power is distributed to thecustomer.  By utilizing the “as billed”method, unbilled revenue was not recognized.

 

Effective January 1, 2003, the Company’s Board of Directors changed therate-making policy to recognize unbilled revenue.  The Company was then required to changeaccounting principles related to its revenue recognition method.  Under the new rate-making structure, theCompany recognizes revenue when power is distributed to the customer, ratherthan when the customer is billed.

 

***Stock Based Compensation.******* Effective January 1, 2003, the Company adoptedthe fair value method of accounting for its employee stock incentive plan inaccordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” asamended by SFAS No. 148, “Accounting for Stock-Based Compensation, Transitionand Disclosure.”

 

***Tax Liabilities and Valuation ofDeferred Tax Assets.**** *The Company is required to assess theultimate realization of deferred tax assets generated from net operatinglosses, and capital losses incurred on the sale of assets.  This assessment takes into consideration taxplanning strategies within our control, including assumptions regarding theavailability and character of future taxable income.

 

At December 31, 2004 and 2003, there were approximately $12,218,000 and$20,800,000, respectively, of net operating loss carryforwards that expire in2021 through 2024, and may be used to offset future taxable income.

 

***Impairment of Long-lived Assets.**** *Management reviews the carrying value of long-lived assets wheneverevents or changes in circumstances indicate that such carrying values may notbe recoverable in accordance with Statement of Financial Accounting StandardsNo. 144, “Accounting for the Impairment or Disposal of Long-lived Assets.”  Unforeseen events and changes in conditionscould indicate that these carrying values may not be recoverable and maytherefore result in impairment charges. An impairment loss is recognized only if the carrying amount of thelong-lived asset is not recoverable and exceeds its fair value.  The carrying amount of a long-lived asset isnot recoverable if it exceeds its future undiscounted cash flows, and ifrequired, fair value of long-lived asset is written down to its fairvalue.  The determination of future cashflows, and if required, fair

 

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value of long-lived asset is by its nature a highly subjectivejudgment.  Fair value is determined bycalculating the discounted future cash flows using a discount rate, third partycontracted bids or appraisals performed by a qualified party.  Significant judgments and assumptions arerequired in the forecast of future operating results used in the preparation ofthe long-term estimated cash flows, including long-term forecasts of theamounts and timing of overall market growth. Changes in these estimates could have a material effect on theassessment of our long-lived assets.

 

***Postretirement Healthcare Benefits.**** *The Company provides certain postretirement healthcare benefits toemployees and retirees.  Determining thecosts associated with such benefit is dependent on various actuarialassumptions including demographics (age, sex), mortality rates, discount ratesused in determining the projected benefit obligations, and current andprojected health care cost trend rates. Independent actuaries perform the required calculations, in accordancewith accounting principles generally accepted in the United States.  Actual results that differ from the actuarialassumptions are generally accumulated and amortized over future periods.

 

**Results of Operations**

 
| ** **               | ** ** | **Year  Ended December 31,** | ** ** |
|--------------------------|------------|------------------------------|------------|
| ** **               | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **               | ** ** | **(Thousands  of dollars)**  | ** ** |
| **Operating  Revenues:** |       |                         |       |   |   |   |   |
| Electric revenues        |       | $                            | 81,149     |   | $ | 81,402 |   | $ | 73,335 |   |
| Other                    |       | 1,475                        |       | 1,442 |   | 1,302 |   |
| Total operating revenues |       | $                            | 82,624     |   | $ | 82,844 |   | $ | 74,637 |   |

 

The consumption and demand for electricity within the Company’s serviceareas is greatly impacted by weather conditions and temperatures.  The hot temperatures during the summermonths, or the third quarter, require residential customers to use moreelectricity in cooling their homes. Rural customers who irrigate crops use more electricity in the summermonths for the irrigation process, and if the spring season didn’t bring muchrain, these customers may irrigate sooner and longer.  Portions of the Company’s service areas hadbeen experiencing a severe long-term drought, but these conditions are muchless severe than in the past.

 

Although electric revenues decreased only $253,000 between 2003 and2004, the aggregate components were:

 

•                  An increase in power cost recovery of$2,702,000;

•                  Increasein wholesale sales and kWh sales of $801,000;

•                  Adecrease in 2004 of $3,755,000 as a result of the 2003 change in accountingprinciple.

 

The increase in power cost recovery is comprised of the increase of thepass through of fuel costs to customers of $4,150,000, and a decrease in theamount of revenue recognition related to a regulatory surcharge authorized bythe Board of Directors of $1,448,000.  Itwas intended to recover some of the expense incurred in connection with theCompany’s response to Opposing Intervenors actions in the CCN case.  A total of $2,354,000 was billed to customersfrom June 2003 through February 2004; $92,000 was recognized as revenue in2004, $1,539,000 was recognized as revenue in 2003, and the remainder of$723,000 is shown as a regulatory liability on the balance sheet at December31, 2004.

 

Electric revenues increased $8,067,000 for 2003 as compared to2002.  This rise is due to multiplefactors:

 

•                  An increase of $4,600,000 for recovery ofpower costs;

•                  Anincrease in revenue accruals of $3,400,000 due to the effect of the change inaccounting principle in 2003.

 

9

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The Company had been realizing deferred revenue of $4,364,000 equallyover a 24 month period from January 2002 to December 2003.  This revenue was recognized equally in boththe 2003 and 2002 periods, and was billed through the power cost recoveryfactor, and is not being reflected in any future periods.  This item related to purchased power that wasexpensed in prior years.

 

Because of a change in thePublic Utility Regulatory Act (“PURA”), as of September 1, 2003, the Company’s rates became subject to regulationand approval by the PUCT, not the Company’s Board of Directors.   In accordance with this change in the PURA,the Company filed its tariffs for electric service on September 2, 2003.  The staff of the PUCT reviewed those tariffsand provided comments and proposed changes to bring the tariffs into compliancewith PUCT rules and regulations.  Becausethe tariffs, when adopted, were not subject to PUCT regulation, some of theprovisions did not comply with PUCT rules and regulations since that was not arequirement when the tariffs were adopted. Now that the Company is subject to PUCT regulation, the Company madeproposed amendments to its tariff as suggested by the PUCT staff.  The PUCT staff reviewed the proposed changesand recommended that the tariff be approved. Prior to the Administrative Law Judge entering a ruling approving thetariff, with the proposed changes, several of the group of intervenors in thecase were successful in obtaining a legislative request that the matter bereferred to the State Office of Administrative Hearings (“SOAH”) for a hearingon the merits.  As a result, the matterwas referred to SOAH and a hearing is currently scheduled for April, 2005.  The hearing will be limited to whether thetariffs filed by the Company are the actual tariffs that were properly approvedby the Company’s Board of Directors, which was the Company’s previousregulatory authority.  The Companybelieves the issue is moot because any current tariff will be superseded by thetariff that is ultimately approved by the PUCT in the current rate case.

 

In October 2004, the PUCTinitiated an inquiry to determine the reasonableness of the Company’s rates andordered the Company to submit a rate filing package.  The Company prepared and filed a rate filingpackage that contained a request for a rate increase for some customerclasses.  The Company initially requesteda $6,333,000 overall annual after tax increase but due to adjustments madewhile preparing for the hearing on the merits in the case, that amount wasadjusted downward to $5,021,000. Hearings were held before the State Office of Administrative Hearingsfrom October 5, 2004, through October 14, 2004. During such hearings, the Company presented testimony and evidence insupport of its requested rate increase. Numerous intervening parties and the PUCT staff presented evidence andtestimony in opposition to the rate increase and in support of a ratedecrease.  The parties have filed briefsin support of their positions.  TheCompany has agreed to extend the effective date for the requested rate increaseuntil June 17, 2005.  A hearing was heldin December 2004, to determine the amount of rate case costs that the PUCT willallow the Company to recover from its customers, as well as the period ofrecovery.  The Company believes all itsrate case costs are reasonable and necessary and should be recoverable.  Any amount not allowed for recovery will beexpensed immediately.  As of December 31,2004, $3,593,000 of third party costs had been incurred in connection with therate case, and are shown on the balance sheet as a regulatory asset.   These costs were deferred pending approvalof recovery by the PUCT.  See also Note11 to the consolidated financial statements.

 

On March 17, 2005, the Administrative Law Judges (“ALJ’s”)issued a Proposal for Decision (“PFD”). The PFD recommended a 7.49% rate decrease for Cap Rock.  This amounts to an annual revenue decrease ofapproximately five million dollars. Several intervenors had sought rate decreases which were much largerthan the recommendation of the ALJ’s.  Afinal ruling, which can be appealed by Cap Rock or any of the intervenors, isexpected by June 2005.

 

The Company feels that its rates and its requestedrate increase are justified and that the evidence supports that.  The Company will request that the PUCT rejectthe recommendation of the ALJ’s and grant its requested rate increase.  The Company has received recommendations fromAdministrative Law Judges in the past which were not in its favor, only toprevail when the issues were considered by the PUCT.  The Company believes its rates are reasonableand that the requested rate increase is appropriate based upon its cost of serviceand reasonable return on its rate base. However, the Company cannot determine what action the PUCT will takewith respect to the PFD.

 

If the Company’s request for a rate increase is approved by the PUCT,the Company may suffer a decline in its customer base.  Because the outcome of the rate request orrate order is unknown, the Company is unable to predict the effect of suchorder.

 

10

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| ** **                    | ** ** | **Year  Ended December 31,** | ** ** |
|-------------------------------|------------|------------------------------|------------|
| ** **                    | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                    | ** ** | **(Thousands  of dollars)**  | ** ** |
| **Operating  Expenses:**      |       |                         |       |
| Purchased power               |       | $                            | 36,958     |   | $ | 36,578 |   | $ | 36,433 |   |
| Disallowed power costs        |       | 3,074                        |       | — |   | — |   |
| Operations and maintenance    |       | 10,331                       |       | 10,135 |   | 7,327 |   |
| General and administrative    |       | 7,518                        |       | 4,639 |   | 7,144 |   |
| Stock compensation            |       | 4,925                        |       | 2,133 |   | — |   |
| Depreciation and amortization |       | 7,416                        |       | 6,719 |   | 5,834 |   |
| Property taxes                |       | 1,925                        |       | 1,345 |   | 1,367 |   |
| Other                         |       | 258                          |       | 326 |   | 202 |   |
| Total operating expenses      |       | $                            | 72,405     |   | $ | 61,875 |   | $ | 58,307 |   |

 

Purchased power expense normally moves in relation to electric demandand consumption.    Contract terms withwholesale power suppliers provide for pricing based upon the price of fuel,demand and usage.    All costs of powerare passed through to the Company’s retail customers.

 

Purchased power increased $380,000 from 2003 to 2004.  The net changes related to:

 

•                  Increase in power costs of $4,754,000; offsetby

•                  Decreaseof $4,412,000 in 2004 because of the conclusion in 2003 of the rate makingtreatment of the capital lease payments associated with the transmissionsystem.

 

Purchased power only increased by $145,000 from 2002 to 2003.  The net change is attributable to:

 

•                  An increase in power costs of $2,966,000which includes $1,318,000 of power cost lag because of the change to theaccrual method of accounting;

•                  Aconclusion in September 2003 to the rate making treatment of the capital leasepayments which were associated with the transmission system.  This caused a decrease of $2,773,000.

 

The cost of natural gas has risen from 2002 to 2004, which increasedthe cost of purchased power and is passed directly through to customers.

 

Rate-making treatment required the Company to classify the amortizationof property and equipment under the capital lease, as well as the associatedinterest expense, as purchased power. Because the lease was extinguished in September 2003, the treatment isno longer applicable, and the remaining net book value of the transmissionsystem is being depreciated over its remaining life, and that expense isreflected in Depreciation and Amortization expense.

 

Disallowed power costs of $3,074,000 in the 2004 period is the increasein fuel cost related to the regulatory liability due to overcollection of powercost recovery.

 

Factors affecting operations and maintenance expense are certainweather conditions such as high winds, ice storms and lightning which causedamage to electric lines and interrupt service. Operations and maintenance increased $196,000 and $2,808,000,respectively, between 2004 and 2003, and 2003 and 2002.  The majority of the change is related to anincreased need in maintenance for the distribution and transmission systemswhich resulted in current expense, as opposed to engaging in constructionactivities that would have resulted in capitalized costs.

 

General and administrative expenses increased by $2,879,000 from 2003to 2004, because of the following:

 

•                  Increased costs in 2004 of $1,610,000 relatedto IT support and outsourced IT functions;

•                  Increasedexpenditures of $218,000 associated with public relations;

 

11

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•                  Decreasedoverhead allocation from 2003 to 2004 to utility plant and operations andmaintenance of $890,000 resulted in higher costs remaining in general andadministrative.

 

General and administrative expenses decreased by $2,505,000 between2002 and 2003, because of decreases in legal and professional fees, themajority 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.

 

The Company expects regular general and administrative expenses toincrease in the future because compliance with PUCT rules and regulations, aswell as the Sarbanes Oxley Act of 2002, will require more resources andpersonnel.

 

In December 2002, the shareholders approved the Stock Incentive Planwhich authorized a total of 800,000 shares under that plan.  See “Equity Compensation Plans” under Item5.  In April 2003, each employee wasgranted a noncash stock award, with vesting over 5 years.  Officers, directors and certain retireddirectors were also granted noncash stock awards in July 2003, with vestingperiods ranging from 2 to 5 years.  Bothawards are being amortized to expense over periods of 2 to 5 years, with theexpense reflecting the fair value of the award.

 

In December 2004, an additional award of stock was granted toemployees, officers and directors. Employee awards vest over two years, and officers’ and directors’ awardsvested immediately.  The fair value ofthis award is being amortized to expense over the applicable vestingperiod.  Expected noncash compensationexpense by year for all awards is as follows: 2005 - $1,225,000, 2006 -$324,000, 2007 - $316,000 and 2008 - $108,000.

 

Depreciation and amortization increased $697,000 from 2003 to 2004because of the following factors:

 

•                  Conclusion in 2003 of the rate makingtreatment of the amortization of property and equipment associated with thetransmission system capital lease caused an increase of $412,000 because thetreatment is no longer applicable;

•                  Amortizationin 2004 of $367,000 relative to the capitalized costs of the IT system.

 

Depreciation and amortization increased $885,000 from the year ended2002 as compared to 2003 for various reasons:

 

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

•                  Conclusionof the rate making treatment of the amortization of property and equipmentassociated with the transmission system capital lease caused an increase of$220,000.

 

In connection with the original ten year capital lease associated withthe transmission 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 is nolonger 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 Amortization expense.  The Company estimates the amount of suchdepreciation on the transmission system to be $864,000 per year.

 

In its efforts to be able to adapt to a changing regulatoryenvironment, enhance efficiency and automate certain processes, managementrecognized the need for a more sophisticated and responsive IT system andassociated applications.  The Companyengaged an outside third party to assess the Company’s current and future ITneeds, assist in the selection process of software and related applications,implement the chosen products and processes and provide ongoing support.  The third party IT firm is also assisting theCompany in providing IT internal control documentation and procedures relatedto compliance with Section 404 of the Sarbanes Oxley Act of 2002.

 

12

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Certain IT costs associated with the change in the operatingenvironment, the software applications and implementation process have beencapitalized.  These costs aggregated$4,486,000 and $3,881,000 at December 31, 2004 and 2003, and the Company begana 5 year amortization period beginning March 2004, which was the end of theplanned implementation.  In addition, theongoing costs for maintenance and IT support are based on the number of metersper respective month and, based on the number of meters as of December 31,2004, will approximate $1,697,000 per year through the term of the contract,which is December 2007.  All applicationsare anticipated to be operational by mid 2005.

 

Historically, property tax expense had remained relativelyconstant.  In 2004, such expensesincreased $580,000 because of current appraisal methodologies used in the advalorem taxation of investor owned utilities in Texas, as well as the Company’srevenue-generating ability, as compared to its former status as a cooperative.

 
| ** **                                          |   | **Year  Ended December 31,** |       |
|-----------------------------------------------------|--------|------------------------------|------------|
| ** **                                          |   | **2004**                     | ** ** | **2003** | ** ** | **2002** |   |
| ** **                                          |   | **(Thousands  of dollars)**  |       |
| **Other  Income (Expense):**                        |   |                         |       |   |   |   |   |
| Allocation of income from associated  organizations |   | $                            | 540        |   | $ | 530 |   | $ | 478 |   |
| Interest expense, net of capitalized  interest      |   | (7,983                       | )          | (8,047 | ) | (7,403 | ) |
| Interest and other income                           |   | 646                          |       | 795 |   | 1,027 |   |
| Impairment of Lamar combination costs               |   | —                       |       | — |   | (1,357 | ) |
| Loss on sale of MAP stock                           |   | —                       |       | (1,056 | ) | — |   |
| Equity earnings in MAP                              |   | —                       |       | 144 |   | 115 |   |
| Shareholders’ Trust                            |   | (129                         | )          | — |   | — |   |
| Total other  income (expense)                       |   | $                            | (6,926     | ) | $ | (7,634 | ) | $ | (7,140 | ) |

 

Interest expense decreased $64,000 between 2003 and 2004 because of thefollowing:

 

•                  Amortization of all remaining fees and costsincurred with respect to the Beal Bank loan caused an increase of $787,000;

•                  Theinitial Beal Bank advance was drawn on in September 2003 and repaid in November2004, with a resulting net increase of $795,000;

•                  Thecross-collateralized note payable to a bank was extinguished in September 2003causing a decrease of $566,000 between the periods;

•                  Interestexpense on mortgage debt reflects a decrease of $126,000 because of thedeclining balance on the debt.

•                  In2004, there was no amortization of the fees and costs associated with theoriginal transmission system capital lease because the lease was extinguishedin September 2003.  This caused adecrease of $984,000.

 

Interest expense increased $644,000 between 2002 and 2003 because ofthe following:

 

•                  Increase of $478,000 because of the draw onthe initial advance from Beal Bank in September 2003 at a rate of 10.75% perannum;

•                  Initialamortization of $333,000 of the legal fees and costs in 2004 incurred withrespect to consummation of the Beal Bank loan;

•                  Amortizationof the fees and costs associated with the original transmission system capitallease were accelerated by $544,000, in order that these costs would be fullyamortized by the end of the lease term;

•                  Decreasein interest on mortgage debt of $535,000 because the Company was able to lockin lower interest rates, coupled with a declining principal balance;

•                  Decreaseof $186,000 in interest associated with the cross-collateralized note payableto a bank because of its declining balance and it was extinguished in September2003.

 

13

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As described more fully in Note 23 to the consolidated financialstatements, in 1999 the Company entered into an agreement to combine with LamarElectric Cooperative (“Lamar”).  Lamarterminated the agreement in late 2002. Although the Company is seeking to recover the costs and expensesincurred in connection with the combination, generally accepted accountingprinciples required the impairment of those capitalized costs, which aggregated$1,357,000.

 

Because the investment in MAP was sold in 2003, the 2004 period willnot reflect any transactions related to MAP.

 

When the Company and the Shareholders’ Trust entered into a VotingAgreement in December 2004, the Company recorded a long term liability based onfair value of $129,000 and a corresponding expense.  This was for consideration whereby the sharesheld by the Trust will be voted by the Trustees as directed by the Company foras long as the shares are held in the Trust. See Note 22 to the consolidated financial statements.

 
| ** **                   | ** ** | **Year  Ended December 31,** | ** ** |
|------------------------------|------------|------------------------------|------------|
| ** **                   | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                   | ** ** | **(Restated)**               | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **(Thousands  of dollars)**  | ** ** |
| **Income  Tax Expense:**     |       |                         |       |   |   |   |   |
| Income tax expense (benefit) |       | $                            | (232       | ) | $ | 2,137 |   | $ | 414 |   |
|                              |            |                              |            |  |  |  |  |  |  |  |

 

Income tax expense decreased $2,369,000 between 2003 and 2004, andincreased $1,723,000 between 2003 and 2002. As of December 31, 2004, the Company has net operating carryforwards ofapproximately $12,218,000 which are scheduled to expire in 2011 through2024.  As of December 31, 2004, the netdeferred tax asset had been eliminated, as well as the valuation allowance, anda net deferred tax liability was recorded for $1,275,000, and a current incometax payable of $633,000.  The decrease inthe valuation allowance from 2003 to 2004 of $5,240,000 is due partially becauseof a change in temporary differences and the resulting net deferred taxes andthe changes in net operating losses between the two years.

 

The Company identified a technical tax issue related to the income taxtreatment, for financial reporting purposes, regarding the exempt status of oneof the Company’s subsidiaries.  Inconnection with the Company’s conversion from an electric cooperative to aninvestor owned utility, the Company had independent professional consultantsevaluate the corporate structure of the Company and its subsidiaries.  Based on that review, the Company believedthe subsidiary would continue to qualify as a tax exempt cooperative.  Therefore, the Company treated the subsidiaryas exempt for both financial and tax reporting purposes.  Recently, in connection with an unrelatedproject, the tax structure of the subsidiary was reviewed and issues aroseconcerning its exempt status.  Because ofthe complex nature of the issue, the Company is seeking guidance from theInternal Revenue Service regarding the taxable nature of the subsidiary.  As a result of the Company’s identificationof the issue, on August 24, 2005, Management and the Audit Committee concludedthat the Company would amend and restate its Annual Report on Form 10-K for theyear ended December 31, 2004, to treat the subsidiary as a taxable entity forfinancial reporting purposes.  TheCompany had generated net operating losses in earlier periods that would beused to offset the taxable nature of the subsidiary.  The use of the net operating losses, earlierthan expected, may result in taxes payable that are greater than originallydisclosed.

 

In early 2004, the IRS notified the Company that it intended to examinethe federal income tax return of the Cooperative for the year 2001.  The Company and the IRS are in the finalstages of that process, and Management believes there will be no impact on theCompany’s financial position or results of operations.

 

14

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**Contractual Obligations and Other Commitments**

 

The following table summarizes the Company’s obligations andcommitments to make future payments under certain contractual obligations:

 
| ** **                             | ** ** | **2005**                   | ** ** | **2006**   | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|----------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| ** **                             | ** ** | **(Thousands of dollars)** | ** ** | ** ** |
| Debt  obligations                      |       | $                          | 7,931      |       | $          | 4,210    |       | $        | 30,589     |     | $          | 3,935          |       | $         | 3,804      |   | $ | 93,285 |   | $ | 143,754 |   |
| Capital  lease obligations             |       | 124                        |       | 72         |       | 31       |       | 17       |       | 17       |       | 25             |       | 283       |       |
| Operating  lease obligations           |       | 485                        |       | 396        |       | 322      |       | 137      |       | 137      |       | 91             |       | 1,568     |       |
| Purchase  obligations (1)              |       | 6,969                      |       | 2,099      |       | 2,099    |       | 402      |       | 402      |       | 2,802          |       | 14,773    |       |
| Other long  term liabilities (2)(3)(4) |       | 1,543                      |       | 1,531      |       | 921      |       | 859      |       | 797      |       | 33,926         |       | 39,577    |       |
|                                        |            |                            |            |            |            |          |            |          |            |          |            |                |            |           |            |  |  |  |  |  |  |  |

 

----

(1)   All of the Company’s power contracts are firm, full requirementscontracts.  These types of contractsrequire the Company to purchase all of its power needs from the seller, but donot mandate a minimum purchase amount. Therefore, amounts included for each year are basic requiredtransmission charges.  Also included arecommitments for IT services and certain professional services.

(2)   Includes actuarially calculated amounts for post retirement healthcarecosts of $849,000, $838,000, $855,000, $827,000, and $776,000 for the yearsended 2005, 2006, 2007, 2008 and 2009, respectively, as well as $33,926,000 forthe years 2010 through 2050.

(3)   The Company has a contract with the City of Farmersville, Texas, to actas an agent to provide power, assume related billing and collections functionsand is obligated to the City to make payments on a revenue sharing type basis.  The 2005, and estimated 2006, annual paymentsaggregate $621,000.

(4)   Payments to or benefits to be provided to advisory directors areincluded.

 

**Liquidity and Capital Resources**

 

As ofDecember 31, 2004, the Company had:

 

•                  Cash and cashequivalents of $20,968,000;

•                  Working capital of$8,527,000; and

•                  Long-term indebtednessof $134,032,000, net of current portion.

 

The Company requires capital to fund utility plantadditions, working capital and other utility expenditures which are recoveredin subsequent and future periods through rates. Capital necessary to meet these cash requirements is now derivedprimarily from internally generated funds.

 

Includedin the $8,527,000 of working capital above, the Company has a $3.4 millionincome tax receivable.  $1.9 million ofthis receivable represents current year income tax overpayments, and $1.4million represents income taxes to be recovered through the carry back to prioryears of the Company’s current year net operating loss.  The Company should receive the $3.4 millionfederal income tax receivable during 2005.

 

TheCompany’s identification of a technical tax issue related to the income taxtreatment, for financial reporting purposes, regarding the tax exempt status ofone of the Company’s subsidiaries has resulted in additional income taxexpense.  This will not require animmediate cash outlay because it affects deferred taxes payable.  The Company had generated net operatinglosses in earlier periods that would be used to offset the taxable nature ofthe subsidiary.  The use of the netoperating losses earlier than expected may also result in increased taxespayable and a comparable decrease in earnings in future periods to the extentof the unavailable net operating losses.

 

Through2001, one of the Company’s primary sources of capital and liquidity had beenborrowings from the Company’s primary lender, National Rural UtilitiesCooperative Finance Corporation (“CFC”). These borrowings

 

15

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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 1.35 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, 2004, the Company was in compliance with its CFCloan agreements and the applicable covenants.  See Note 12 to theconsolidated financial statements for a discussion of CFC’s waivers related tothe prior conversion from a cooperative to a stock holder owned corporation.

 

Substantially all of the CFCmortgage notes are subject to interest rate repricing at the end of variousperiods, at the Company’s option.  TheCompany anticipates refinancing one of the mortgage notes that has a balloonpayment of $26,367,000 due in 2007. Mortgage notes with CFC as of December 31, 2004, and the applicableinterest rates are as follows:

 

| **Interest Rate**   | ** ** | **Repricing in  January** | ** ** | **Amount** | ** **  |
|---------------------|------------|---------------------------|------------|------------|-------------|
| ** **          | ** ** | ** **                | ** ** | ** ** | ** **  | ** ** | ** ** |
| Fixed               |       | 4.85                      | %          | 2006       |        | $ | 6,467,000 |   |
| Fixed               |       | 5.15                      | %          | 2007       |        | 64,055,000 |   |
| Fixed               |       | 4.70                      | %          | 2006       |        | 33,017,000 |   |
| Fixed               |       | 4.50                      | %          | 2007       |        | 5,960,000 |   |
| Fixed               |       | 4.30                      | %          | —     |        | 27,872,000 |   |
| Fixed               |       | 7.00                      | %          | —     |        | 2,000 |   |
| Fixed               |       | 4.20                      | %          | —     |        | 3,590,000 |   |
| Variable            |       | —                    |       | —     |        | 2,791,000 |   |
| Total mortgage debt |       |                      |       | $          | 143,754,000 |   |

 

FERC approval was received in August 2003 for NewCorp to borrow$31,500,000 from Beal Bank S.S.B. (“Beal Bank”).  The initial advance of $14,169,000 was usedfor payment of the balloon payment on the transmission system capital lease inSeptember 2003.  Simultaneously, thesinking fund of $8,207,000 was released by the lessee, and used to partiallyfund a restricted securities account of $14,169,000, which was the only assetcollateralized by Beal Bank.

 

Interest on the Beal Bankloan was 10.75%, payable monthly.  Thefinancing arrangement provided for a commitment fee, which totaled $457,000 forthe initial advance.  Additional amountspaid to Beal Bank were reimbursement of expenses, attorney fees, appraisals andconsulting, which at December 31, 2004, aggregated $1,184,000.  Prepayment of the initial advance was notallowed unless the additional advance was funded before the September 9, 2004,original due date.  Two amendments to thefinancing agreement extended the due date of the initial advance, and thecollateralized securities account was then used to repay the initial advance inNovember 2004.  In the accompanyingconsolidated balance sheet at December 31, 2003, the initial advance of$14,169,000 is shown in current liabilities because it was not certain that theCompany would draw on the additional advance from Beal Bank.

 

Stock awards were made toemployees, officers and directors in both 2004 and 2003.  Noncash compensation expense of $4,925,000and $2,135,000 was recorded for 2004 and 2003, because the fair value of theaward is being amortized over each of the applicable vesting periods.  Expected noncash compensation expense by yearis as follows:  2005 - $1,225,000, 2006 -$324,000, 2007 - $316,000 and 2008 - $108,000.

 

The terms of the notereceivable agreement with the shareholder of United Fuel provide for repaymentafter United Fuel has completed certain capitalization arrangements.   All conditions required pursuant to theagreement have been satisfied, and the Company expects full payment of the$1,300,000 in 2005.

 

When the Company and the CapRock Energy Shareholders’ Trust entered into a Voting Agreement in December2004, the Company recorded a long term liability based on fair value of$129,000 and a

 

16

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corresponding expense.  This was for consideration whereby the sharesheld by the Trust will be voted by the Trustees but as directed by the Companyfor as long as the shares are held in the Trust.  This liability will be paid out as the ownersof the shares are located and the shares are issued to the owner or theirheirs.  Therefore, this liability will bepaid over future years, and is not expected to require a material amount ofcash in any one year.  See Note 22 to theconsolidated financial statements.

 

The Company providescontinued major medical coverage to retired employees and theirdependents.  The actuarially calculatedestimates of costs for future years is shown in the table under “ContractualObligations and Other Commitments.”  Aone percentage point change in assumed health care cost trend rates would havethe following effects:

 
| ** **                                                | ** ** | **One Percentage Point** | ** ** |
|-----------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                | ** ** | **Increase**             | ** ** | **Decrease** | ** ** |
| Effect on  total of service cost and interest cost        |       | $                        | 133        |   | $ | (105 | ) |
| Effect on  accumulated post retirement benefit obligation |       | 1,392                    |       | (1,136 | ) |
|                                                           |            |                          |            |  |  |  |  |

 

Although the outcome concerning the PUCT’s final order on the Company’sretail rates are unknown, with the current working capital position and theavailability of other capital, Management feels the Company has adequateresources to meet its obligations for 2005, including those enumerated in thetable under “Contractual Obligations and Other Commitments.”

 

**NewAccounting Standards**

 

In December 2004, the FASBissued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R revises SFAS No. 123, “Accounting for Stock-BasedCompensation.”  This new standardgenerally requires the cost associated with employee services received inexchange for an award of equity instruments be measured based on the grant-datefair value of the award and recognized in the financial statements over theperiod during which the employee is required to provide services in exchangefor the award.  SFAS No. 123R alsoprovides guidance on how to determine the grant-date fair value for awards ofequity instruments, as well as alternative methods of adopting itsrequirements.  SFAS No. 123R is effectiveas of the beginning of the first interim or annual reporting period after June15, 2005, and applies to all outstanding and unvested share-based paymentawards at a company’s adoption date.  TheCompany changed its method of accounting from the intrinsic method per APBOpinion No. 25, to the fair value method per SFAS No. 148, effective January 1,2003.  Therefore, SFAS No. 123R is notexpected to have an impact on the Company’s consolidated financial statements.

 

In May 2004, the FinancialAccounting Standards Board issued Staff Position No. 106-2, “Accounting andDisclosure Requirements Related to the Medicare Prescription Drug, Improvementand Modernization Act of 2003” (“FSP 106-2”).  FSP 106-2 permits a sponsor of a postretirement health care plan thatprovides a prescription drug benefit to make a one-time election to defer accountingfor the effects of the Medicare Act and requires certain disclosures pendingdetermination as to whether the sponsor’s postretirement health care planreasonably expect to qualify for beneficial treatment under the Act.  The Company qualifies for the subsidy, whichapproximates $34,000 for the year ended December 31, 2004.  See Note 16.

 

**ITEM8.  Financial Statements andSupplementary Data**

 

The consolidated financialstatements are set forth on pages F-1 through F-36 of this Form 10-K/A.

 

**ITEM9(a).****          CONTROLSAND PROCEDURES**

 

**DisclosureControls and Procedures.**  We maintain disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in reports under the Securities Exchange Act of 1934, as amended, arerecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and that such information is accumulated andcommunicated to management, including our chief executive officer and chieffinancial officer, as appropriate, to allow timely decisions regarding required

 

17

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disclosures.  Our internal control system is designed toprovide reasonable assurance regarding the preparation and fair presentation ofpublished financial statements.  Allinternal control systems are designed based in part upon certain assumptionsabout the likelihood of future events, and, no matter how well designed, haveinherent limitations.  Therefore, eventhose systems determined to be effective can provide only reasonable assurancewith respect to financial statement presentation and may not prevent or detectall misstatements.

 

During the period covered bythis report, the Company’s chief executive officer and chief financial officer,after evaluating the effectiveness of the Company’s “disclosure controls andprocedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e)and 15d-15(e)) as of December 31, 2004, (the “Evaluation Date”), had concludedthat as of the Evaluation Date, the Company’s disclosure controls andprocedures (as required by paragraph (b) of the Securities Exchange Act of 1934Rules 13a-15 or 15d-15) were effective.

 

**Restatementof Previously Issued Consolidated Financial Statements.** Subsequent to the Evaluation Date, it was determined that certain taxpositions maintained by the Company through its conversion from an electriccooperative to an investor owned utility, might not be correct.   In connection with that change in corporatestatus, the Company had independent professional consultants evaluate thecorporate structure of the Company and its subsidiaries.  Based on that review, the Company believedthe subsidiary would continue to qualify as a tax exempt cooperative.  Therefore, the Company treated the subsidiaryas tax exempt for both financial and tax reporting purposes.  Recently, in connection with an unrelatedproject, the tax structure of the subsidiary was reviewed and issues aroseconcerning its exempt status.  Because ofthe complex nature of the issue, the Company is seeking guidance from theInternal Revenue Service regarding the taxable nature of the subsidiary.  As a result of the Company’s identificationof the issue, on August 24, 2005, Management and the Audit Committee concluded,after consultation with its independent accountants, that the Company wouldamend and restate its Annual Report on Form 10-K for the year ended December31, 2004, to treat the subsidiary as a taxable entity for financial reportingpurposes.  The Company had generated netoperating losses in earlier periods that would be used to offset the taxablenature of the subsidiary.  The use of thenet operating losses, earlier than expected, may result in taxes payable thatare greater than originally disclosed.

 

After reviewing thecircumstances leading to the issue discussed above, it has been determined thatthere was a material weakness in the Company’s internal controls over financialreporting.  The weakness concernedreliance on the opinions of the Company’s outside professionals, and controlssurrounding procedures associated with issues and positions proposed by outsideprofessional consultants that are adopted by the Company.   The Company’s chief executive officer andchief financial officer have concluded that the Company’s disclosure controlsand procedures over financial reporting were not effective at December 31,2004, to enable the Company to record, process, summarize and reportinformation required to be included in the Company’s SEC filings within therequired time period, and to ensure that such information is accumulated andcommunicated to management, including our chief executive officer and chieffinancial officer, to allow timely decisions regarding required disclosure.

 

**Changes inInternal Control over Financial Reporting.**  Therewere no changes in the Company’s internal control over financial reporting inconnection with the evaluation required by paragraph (d) of the SecuritiesExchange Act of 1934 Rules 13a-15 or 15d-15, that occurred during the quarterended December 31, 2004, that materially affected, or that were reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

Subsequent to theidentification of the tax matter discussed above, Management determined that itwould implement additional procedures for evaluating issues and positionsproposed by independent professional consultants that are adopted by theCompany.  These procedures includeformalizing the process for adoption of any outside professional opinion; if aquestion arises as to the position taken, notification to executive managementand the Audit Committee; and seeking further professional opinions and/orguidance.  The Company’s management hasimplemented these additional controls surrounding procedures associated withissues and positions proposed by outside professional consultants that areadopted by the Company, and believe that the controls now in place are adequateto assure that similar errors will not recur.

 

18

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**PART IV**

 

**ITEM 15. EXHIBITS, FINANCIAL STATEMENTSCHEDULES AND REPORTS ON FORM 8K**

 

**FinancialStatements**

 

For a list of theconsolidated financial statements filed as part of this Form 10-K/A, see theIndex to Consolidated Financial Statements on page F-1.

 

**FinancialStatement Schedule**

 

The following financialstatement schedule is included in Item 14: Schedule II - Valuation andQualifying Accounts for the years ended December 31, 2004, 2003 and 2002.

 

19

----

 

**Exhibits**

 
| **Exhibit No.** | ** ** | **Item**                                                                                                                                               |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                   |
| Exhibit 31.1    |       | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 (Principal Executive Officer)                                                 |
| Exhibit 31.2    |       | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 (Principal Financial Officer)                                                 |
| 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 (Principal Executive  Officer) |
| 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 (Principal Financial  Officer) |

 

20

----

 

**SIGNATURES**

 

In accordance with therequirements of the Securities Act of 1934, as amended, the Registrantcertifies that it has reasonable grounds to believe that it meets all of therequirements for filing Form 10K/A and authorizes this Form 10K/A to be signedon its behalf by the undersigned, thereunto duly authorized, in the City ofMidland, Texas, on October 3, 2005.

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

 

Pursuant to the requirements of the Securities Exchange Act of 1934this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**            | ** ** | **Title**                                                                                               | ** ** | **Date**        |
|--------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|-----------------|
|                     |       |                                                                                                    |       |            |
| /s/ DAVID W. PRUITT      |       | Director, Co-Chairman of  the Board,                                                                    |       | October 3, 2005 |
| David W. Pruitt          |       | Chief Executive Officer                                                                                 |       |            |
|                     |       | (Principal Executive  Officer)                                                                          |       |            |
|                     |       |                                                                                                    |       |            |
| /s/ CELIA B. PAGE        |       | Vice President, Chief  Accounting Officer,                                                              |       | October 3, 2005 |
| Celia B. Page            |       | Assistant  Secretary/Treasurer  and Controller  (Principal Financial and  Principal Accounting Officer) |       |            |
|                     |       |                                                                                                    |       |            |
| /s/ WILLIAM L. WEST      |       | Director, President                                                                                     |       | October 3, 2005 |
| William L. West          |       |                                                                                                    |       |            |
|                     |       |                                                                                                    |       |            |
| /s/ RUSSELL E. JONES     |       | Director, Co-Chairman of  the Board                                                                     |       | October 3, 2005 |
| Russell E. Jones         |       |                                                                                                    |       |            |
|                     |       |                                                                                                    |       |            |
| /s/ S. D. BUCHANAN       |       | Director                                                                                                |       | October 3, 2005 |
| S. D. Buchanan           |       |                                                                                                    |       |            |
|                     |       |                                                                                                    |       |            |
| /s/ FLOYD L. RITCHEY     |       | Director                                                                                                |       | October 3, 2005 |
| Floyd L. Ritchey         |       |                                                                                                    |       |            |
|                     |       |                                                                                                    |       |            |
| /s/ MICHAEL D. SCHAFFNER |       | Director                                                                                                |       | October 3, 2005 |
| Michael D. Schaffner     |       |                                                                                                    |       |            |

 

21

----

 

**CAP ROCK ENERGY CORPORATION**

**SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS**

**ALLOWANCE 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,  2004          |       | $                                                | 78         |                                            | $          | 151                                       |       | $                                         | 114        |   | $ | 115 |   |
| December 31,  2003          |       | $                                                | 50         |                                            | $          | 113                                       |       | $                                         | 85         |   | $ | 78 |   |
| December 31,  2002          |       | $                                                | 202        |                                            | $          | 113                                       |       | $                                         | 265        |   | $ | 50 |   |

 

22

----

 

**INDEX TO FINANCIAL STATEMENTS**

 
| Report of  Independent Registered Public Accounting Firm, KPMG LLP                              |   |   |
|-------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                            |   |   |
| Consolidated Statements of Operations  Years ended December 31, 2004 (Restated), 2003 and 2002  |   |   |
|                                                                                            |   |   |
| Consolidated Balance Sheets  December 31, 2004 (Restated) and 2003                              |   |   |
|                                                                                            |   |   |
| Consolidated Statements of  Equity  Years ended December 31, 2004 (Restated), 2003 and 2002     |   |   |
|                                                                                            |   |   |
| Consolidated Statements of  Cash Flows  Years ended December 31, 2004 (Restated), 2003 and 2002 |   |   |
|                                                                                            |   |   |
| Notes to  Consolidated Financial Statements                                                     |   |   |

 

F-1

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

The Board of Directors and StockholdersCap Rock Energy Corporation:

 

We have audited the accompanying consolidated balance sheets of CapRock Energy Corporation and subsidiaries (the Company) as of December 31, 2004(restated) and 2003, and the related consolidated statements of operations,statement of equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2004.  Inconnection with our audits of the consolidated financial statements, we alsohave audited financial statement schedule II.  These consolidated financial statements and financial statement scheduleare the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements and financial statement schedulebased on our audits.

 

We conducted our auditsin accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of Cap RockEnergy Corporation and subsidiaries as of December 31, 2004 (restated) and2003, and the results of their operations and their cash flows for each of theyears in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted account principles. Also in our opinion, the related financial statement schedule, whenconsidered in relation to the basic financial statements taken as a whole,presents fairly, in all material respects, the information set forth therein.

 

As discussed in Note 2, the accompanying consolidated balance sheet asof December 31, 2004, and the related consolidated statements of operations,statement of equity, and cash flows for the year ended December 31, 2004, havebeen restated.

 

 
|                                     | KPMG LLP |
|------------------------------------------|----------|
|                                     |
| Midland, Texas                           |
| March 25, 2005, except as to             |
| Note 2 which is as of September 30, 2005 |

 

F-2

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                          | ** ** | **YEAR ENDED DECEMBER 31,**                                     | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2004**                                                        | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                          | ** ** | **(Restated)**                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                          | ** ** | **(Thousands of dollars except shares  and per share amounts)** | ** ** |
| **Operating  Revenues:**                            |       |                                                            |       |   |   |   |   |
| Electric revenues                                   |       | $                                                               | 81,149     |   | $ | 81,402 |   | $ | 73,335 |   |
| Other                                               |       | 1,475                                                           |       | 1,442 |   | 1,302 |   |
| Total operating revenues                            |       | 82,624                                                          |       | 82,844 |   | 74,637 |   |
|                                                |       |                                                            |       |   |   |   |   |
| **Operating  Expenses:**                            |       |                                                            |       |   |   |   |   |
| Purchased power                                     |       | 36,958                                                          |       | 36,578 |   | 36,433 |   |
| Disallowed power costs                              |       | 3,074                                                           |       | — |   | — |   |
| Operations and maintenance                          |       | 10,331                                                          |       | 10,135 |   | 7,327 |   |
| General and administrative                          |       | 7,518                                                           |       | 4,639 |   | 7,144 |   |
| Stock compensation                                  |       | 4,925                                                           |       | 2,133 |   | — |   |
| Depreciation and amortization                       |       | 7,416                                                           |       | 6,719 |   | 5,834 |   |
| Property taxes                                      |       | 1,925                                                           |       | 1,345 |   | 1,367 |   |
| Other                                               |       | 258                                                             |       | 326 |   | 202 |   |
| Total operating expenses                            |       | 72,405                                                          |       | 61,875 |   | 58,307 |   |
|                                                |       |                                                            |       |   |   |   |   |
| **Operating  Income**                               |       | 10,219                                                          |       | 20,969 |   | 16,330 |   |
|                                                |       |                                                            |       |   |   |   |   |
| **Other  Income (Expense):**                        |       |                                                            |       |   |   |   |   |
| Allocation of income from associated  organizations |       | 540                                                             |       | 530 |   | 478 |   |
| Interest expense, net of capitalized  interest      |       | (7,983                                                          | )          | (8,047 | ) | (7,403 | ) |
| Interest and other income                           |       | 646                                                             |       | 795 |   | 1,027 |   |
| Impairment of Lamar combination costs (Note  5)     |       | —                                                          |       | — |   | (1,357 | ) |
| Loss on sale of MAP stock                           |       | —                                                          |       | (1,056 | ) | — |   |
| Equity earnings in MAP (Note 8)                     |       | —                                                          |       | 144 |   | 115 |   |
| Stockholders’ Trust                            |       | (129                                                            | )          | — |   | — |   |
| Total other income (expense)                        |       | (6,926                                                          | )          | (7,634 | ) | (7,140 | ) |
|                                                |       |                                                            |       |   |   |   |   |
| **Income  (loss) before income taxes**              |       | 3,293                                                           |       | 13,335 |   | 9,190 |   |
|                                                |       |                                                            |       |   |   |   |   |
| **Income  tax expense (benefit):**                  |       |                                                            |       |   |   |   |   |
| Current                                             |       | (1,507                                                          | )          | 2,137 |   | 414 |   |
| Deferred                                            |       | 1,275                                                           |       | — |   | — |   |
| Total income tax expense (benefit)                  |       | (232                                                            | )          | 2,137 |   | 414 |   |
|                                                |       |                                                            |       |   |   |   |   |
| **Net  income**                                     |       | $                                                               | 3,525      |   | $ | 11,198 |   | $ | 8,776 |   |
|                                                |       |                                                            |       |   |   |   |   |
| **Net  income per common share:**                   |       |                                                            |       |   |   |   |   |
| Basic                                               |       | $                                                               | 2.28       |   | $ | 7.69 |   | $ | 6.74 |   |
| Diluted                                             |       | $                                                               | 2.21       |   | $ | 7.41 |   | $ | 6.74 |   |
|                                                |       |                                                            |       |   |   |   |   |
| **Weighted  average number of shares outstanding:** |       |                                                            |       |   |   |   |   |
| Basic                                               |       | 1,546,271                                                       |       | 1,455,443 |   | 1,302,355 |   |
| Diluted                                             |       | 1,596,796                                                       |       | 1,510,741 |   | 1,302,355 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

F-3

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                 | ** ** | **DECEMBER 31,**           | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                 | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                                 | ** ** | **(Restated)**             | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                                                                 | ** ** | **(Thousands of dollars)** | ** ** |
| **ASSETS**                                                                                                                                                                                                                 |       |                       |       |   |   |
| **Current  Assets:**                                                                                                                                                                                                       |       |                       |       |   |   |
| Cash                                                                                                                                                                                                                       |       | $                          | 20,968     |   | $ | 12,170 |   |
| Restricted cash investment                                                                                                                                                                                                 |       | —                     |       | 14,169 |   |
| Accounts receivable:                                                                                                                                                                                                       |       |                       |       |   |   |
| Electric sales, net                                                                                                                                                                                                        |       | 7,313                      |       | 8,500 |   |
| Other                                                                                                                                                                                                                      |       | 457                        |       | 371 |   |
| Current notes receivable (Notes 8 and 14)                                                                                                                                                                                  |       | —                     |       | 1,250 |   |
| Other current assets (Note 7)                                                                                                                                                                                              |       | 5,431                      |       | 1,587 |   |
| **Total current assets**                                                                                                                                                                                                   |       | 34,169                     |       | 38,047 |   |
|                                                                                                                                                                                                                       |       |                       |       |   |   |
| **Utility  plant, net (Note 9)**                                                                                                                                                                                           |       | 149,361                    |       | 152,162 |   |
| **Investments  and notes receivable (Note 8)**                                                                                                                                                                             |       | 11,004                     |       | 10,045 |   |
| **Nonutility  property, net (Note 10)**                                                                                                                                                                                    |       | 1,227                      |       | 1,545 |   |
| **Regulatory  and other assets (Note 11)**                                                                                                                                                                                 |       | 3,926                      |       | 1,190 |   |
| **Total Assets**                                                                                                                                                                                                           |       | $                          | 199,687    |   | $ | 202,989 |   |
|                                                                                                                                                                                                                       |       |                       |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                              |       |                       |       |   |   |
|                                                                                                                                                                                                                       |       |                       |       |   |   |
| **Current  Liabilities:**                                                                                                                                                                                                  |       |                       |       |   |   |
| Current portion of long-term debt                                                                                                                                                                                          |       | $                          | 10,005     |   | $ | 4,654 |   |
| Short-term note payable                                                                                                                                                                                                    |       | —                     |       | 14,169 |   |
| Accounts payable:                                                                                                                                                                                                          |       |                       |       |   |   |
| Purchased power                                                                                                                                                                                                            |       | 3,823                      |       | 2,798 |   |
| Other                                                                                                                                                                                                                      |       | 3,603                      |       | 2,679 |   |
| Purchased power cost subject to refund                                                                                                                                                                                     |       | 4,376                      |       | 203 |   |
| Accrued and other current liabilities (Note  15)                                                                                                                                                                           |       | 3,202                      |       | 3,902 |   |
| Current income tax payable (Note 24)                                                                                                                                                                                       |       | 633                        |       | 562 |   |
| **Total current liabilities**                                                                                                                                                                                              |       | 25,642                     |       | 28,967 |   |
|                                                                                                                                                                                                                       |       |                       |       |   |   |
| **Long-Term  Debt, Net of Current Portion:**                                                                                                                                                                               |       |                       |       |   |   |
| Mortgage notes (Note 12)                                                                                                                                                                                                   |       | 133,873                    |       | 143,188 |   |
| Note payable and other capital leases  (Notes 13 and 14)                                                                                                                                                                   |       | 159                        |       | 184 |   |
| **Total long-term debt**                                                                                                                                                                                                   |       | 134,032                    |       | 143,372 |   |
|                                                                                                                                                                                                                       |       |                       |       |   |   |
| **Deferred  Credits (Note 17)**                                                                                                                                                                                            |       | 6,569                      |       | 3,677 |   |
|                                                                                                                                                                                                                       |       |                       |       |   |   |
| **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, 1,733,835 shares issued and 1,617,640 shares  outstanding at December 31, 2004 and 1,650,395 issued and 1,567,725  outstanding at December 31, 2003 |       | 17                         |       | 17 |   |
| Paid in capital                                                                                                                                                                                                            |       | 11,683                     |       | 7,815 |   |
| Retained earnings                                                                                                                                                                                                          |       | 23,499                     |       | 19,974 |   |
| Less Treasury stock of 116,195 and 82,670  shares atDecember 31, 2004 and 2003, respectively                                                                                                                               |       | (1,755                     | )          | (833 | ) |
| **Total stockholders’ equity**                                                                                                                                                                                        |       | 33,444                     |       | 26,973 |   |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                                        |       | $                          | 199,687    |   | $ | 202,989 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

F-4

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATED STATEMENTS OF EQUITY**

 
| ** **                                                                                                       | ** ** | **(Thousands  of dollars except number of shares)** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **Successor**                                       | ** ** | **Predecessor** | ** ** |
| ** **                                                                                                       | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Patronage  Capital** | ** ** | **Total** | ** ** |
| ** **                                                                                                       | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Total** | ** ** | **Other** | ** ** | **Obligated  to be** | ** ** | **Margins** | ** ** |
| **Common  Stock**                                                                                                | ** ** | **Paid in**                                         | ** ** | **Retained** | ** ** | **Stockholders’** | ** ** | **Equities  and** | ** ** | **converted  to** | ** ** | **and** | ** ** |
| **# shares**                                                                                                     | ** ** | **Value**                                           | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Equity** | ** ** | **Margins** | ** ** | **Shareholder  Equity** | ** ** | **Equities** | ** ** |
| **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 |   | — |   | — |   | — |   |
|                                                                                                                  |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

F-5

----

 
| ** **                                                                                                               | ** ** | **(Thousands  of dollars except number of shares)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **Successor**                                       | ** ** |
| ** **                                                                                                               | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Total** | ** ** |
| **Common Stock**                                                                                                         | ** ** | **Paid in**                                         | ** ** | **Retained** | ** ** | **Treasury Stock** | ** ** | **Stockholders’** |
| **# shares**                                                                                                             | ** ** | **Value**                                           | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **# of Shares** | ** ** | **Value** | ** ** | **Equity** |
|                                                                                                                     |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **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 |   | 1,902 |   |   |   |   |   |   |   | 1,898 |   |
| Unvested shares  forfeited                                                                                               |       | (900                                                | )          |   |   | (17 | ) |   |   |   |   |   |   | (9 | ) |
| Repurchase of  common stock                                                                                              |       |                                                |       |   |   |   |   |   |   | (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 |   | 7,815 |   | 19,974 |   | (82,670 | ) | (833 | ) | 26,973 |   |
|                                                                                                                     |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock awarded  through Stock Incentive Plan, net of shares withheld for taxes and  amortization of deferred compensation |       | 81,050                                              |       |   |   | 3,894 |   |   |   | (31,500 | ) | (850 | ) | 3,027 |   |
|                                                                                                                     |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock awarded  through Stock for Compensation Plan                                                                       |       | 5,790                                               |       |   |   | 64 |   |   |   |   |   |   |   | 64 |   |
|                                                                                                                     |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Unvested shares  forfeited                                                                                               |       | (3,400                                              | )          |   |   | (90 | ) |   |   |   |   |   |   | (73 | ) |
|                                                                                                                     |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Repurchase of  common stock                                                                                              |       |                                                |       |   |   |   |   |   |   | (2,025 | ) | (72 | ) | (72 | ) |
|                                                                                                                     |       |                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income  (Restated)                                                                                                   |       |                                                |       |   |   |   |   | 3,525 |   |   |   |   |   | 3,525 |   |
| **Balance,  December 31, 2004 (Restated)**                                                                               |       | 1,733,835                                           |       | $ | 17 |   | $ | 11,683 |   | $ | 23,499 |   | (116,195 | ) | $ | (1,755 | ) | $ | 33,444 |   |
|                                                                                                                          |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

F-6

----

 

**CAP ROCKENERGY CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                         | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                         | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                         | ** ** | **(Restated)**              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                         | ** ** | **(Thousands of dollars)**  | ** ** |
| **Cash Flows From Operating Activities:**                                          |       |                        |       |   |   |   |   |
| Net income                                                                         |       | $                           | 3,525      |   | $ | 11,198 |   | $ | 8,776 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                        |       |   |   |   |   |
| Depreciation and amortization                                                      |       | 7,416                       |       | 9,709 |   | 8,953 |   |
| Amortization of debt issue costs                                                   |       | 896                         |       | 1,063 |   | 300 |   |
| Noncash deferred compensation expense                                              |       | 3,804                       |       | 2,020 |   | — |   |
| Write off of investments in proposed  acquisitions                                 |       | —                      |       | — |   | 1,357 |   |
| Equity earnings in Map                                                             |       | —                      |       | (144 | ) | (115 | ) |
| Loss on equity method investment value                                             |       | —                      |       | 1,056 |   | — |   |
| Change in:                                                                         |       |                        |       |   |   |   |   |
| Other assets/deferred credits                                                      |       | 2,892                       |       | (1,756 | ) | 5,909 |   |
| Accounts receivable                                                                |       | 1,127                       |       | (3,811 | ) | (921 | ) |
| Income tax receivable                                                              |       | (3,353                      | )          | — |   | — |   |
| Purchased power cost subject to refund                                             |       | 4,173                       |       | 3,704 |   | (3,888 | ) |
| Other current assets                                                               |       | (446                        | )          | (1,059 | ) | (6,386 | ) |
| Accounts payable and accrued expenses                                              |       | 1,314                       |       | 1,284 |   | (735 | ) |
| Net cash provided by operating activities                                          |       | 21,348                      |       | 23,264 |   | 13,250 |   |
| **Cash Flows From Investing Activities**                                           |       |                        |       |   |   |   |   |
| Utility plant additions                                                            |       | (4,583                      | )          | (5,209 | ) | (1,517 | ) |
| Proceeds from liquidation of investments                                           |       | 913                         |       | 1,511 |   | 1,043 |   |
| Issuance of notes receivable                                                       |       | (1,586                      | )          | (1,250 | ) | — |   |
| Collection of notes receivable                                                     |       | 1,250                       |       | 12,490 |   | 1,000 |   |
| Net cash provided by (used in) investing  activities                               |       | (4,006                      | )          | 7,542 |   | 526 |   |
| **Cash Flows From Financing Activities:**                                          |       |                        |       |   |   |   |   |
| Proceeds from other long-term debt and  capital leases                             |       | 113                         |       | 14,169 |   | 534 |   |
| Payments on mortgage notes                                                         |       | (3,966                      | )          | (3,704 | ) | (3,034 | ) |
| Payments on other long-term debt and  capital leases                               |       | (136                        | )          | (30,246 | ) | (6,387 | ) |
| Payment of short-term note payable                                                 |       | (14,169                     | )          | — |   | — |   |
| Debt issuance costs                                                                |       | (3,632                      | )          | (1,208 | ) | — |   |
| Restricted cash investment                                                         |       | 14,169                      |       | (5,962 | ) | — |   |
| Repurchase/acquisition of common stock                                             |       | (923                        | )          | (852 | ) | — |   |
| Retirement of former member equity                                                 |       | —                      |       | (732 | ) | (488 | ) |
| Net cash used in financing activities                                              |       | (8,544                      | )          | (28,535 | ) | (9,375 | ) |
| **Increase in Cash and Cash Equivalents:**                                         |       | 8,798                       |       | 2,271 |   | 4,401 |   |
| Cash at beginning of year                                                          |       | 12,170                      |       | 9,899 |   | 5,498 |   |
| Cash at end of year                                                                |       | $                           | 20,968     |   | $ | 12,170 |   | $ | 9,899 |   |
| **Noncash financing activities:**                                                  |       |                        |       |   |   |   |   |
| Deferred compensation related to stock  awards                                     |       | $                           | 471        |   | $ | 3,695 |   | $ | — |   |
| **Supplemental Cash Flow Information**                                             |       |                        |       |   |   |   |   |
| Cash paid during the year for interest                                             |       | $                           | 7,045      |   | $ | 6,640 |   | $ | 8,611 |   |
| Cash paid during the year for income taxes                                         |       | $                           | 1,450      |   | $ | 1,950 |   | $ | — |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

F-7

----

 

**CAP ROCKENERGY CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER31, 2004, 2003 AND 2002**

 

**1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**General**

 

Cap Rock Energy Corporation, Inc. (the “Company” or the “Successor”)was formed in December 1998 in accordance with a conversion plan to reorganizea member owned electric cooperative, Cap Rock Electric Cooperative, Inc. (the “Cooperative”or the “Predecessor”) to a shareholder owned business corporation.   The Cooperative was incorporated as anelectric cooperative in the State of Texas in 1939 to provide electricdistribution services and power to its members. The Company currently provides service to approximately 35,000 meters in28 counties covering approximately 13,000 square miles in Texas.  Its customers, which are principallyresidential, commercial and irrigation, are located in the Midland-Stanton areaof west Texas, the central Texas area around Brady, and in northeast Texas inHunt, Collin and Fannin Counties. Through its subsidiaries, the Company 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**

 

The accompanying consolidated financial statements include the accountsof the Company, 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 Cooperative was dissolved in March2004.  Energy and NewCorp maintainaccounting records in accordance with the uniform system of accounts, asprescribed by the Federal Energy Regulatory Commission (“FERC”).

 

All significant intercompany balances and transactions have beeneliminated in consolidation.  Unlessotherwise indicated, all references to the Company will include any and allactivities of its Predecessor.

 

**Use of Estimates**

 

In conformity with accounting principles generally accepted in theUnited States, the preparation of the Company’s consolidated financialstatements requires management to make estimates and assumptions with respectto values or conditions which cannot be known with certainty, that affect therecorded amounts of assets and liabilities, disclosure of contingent assets andliabilities and the recorded amounts of revenues and expenses.  Actual results could differ from thoseestimates.  Items which may be estimatedinclude, but are not limited to, the economic useful lives of assets, fairvalues of assets and liabilities, impairment of goodwill, obligations underemployee benefit plans, valuation allowances for receivables and deferred tax assets,unbilled revenues for distribution services and electricity provided for whichmeters have not been read, and various other recorded or disclosed amounts.

 

**Regulatory Accounting**

 

The Company’s principal business is the transmission and distributionof electricity through NewCorp and Energy, respectively.  NewCorp is subject to regulation by theFederal Energy Regulatory Commission, and Energy is now regulated by the PublicUtility Commission of Texas (“PUCT”). Accordingly, the Company accounts for the effects of regulation pursuantto 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 andcollected from customers.  If an entity meets the above three criteria,it is required to capitalize costs that would otherwise be charged to expenseif the actions of the regulating body make it probable that those costs

 

F-8

----

 

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. Regulatory liabilities represent probable future reductions in revenuesassociated with amounts that are expected to be credited to customers throughthe rate making process.

 

The significant regulatory assets and liabilities are as follows:

 
| ** **                                                                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                | ** ** | **2004**         | ** ** | **2003** | ** ** |
| **Assets:**                                                                               |       |             |       |   |   |
| Rate case costs                                                                           |       | $                | 3,593,000  |   | $ | 145,000 |   |
|                                                                                      |       |             |       |   |   |
| **Liabilities:**                                                                          |       |             |       |   |   |
| Purchased power subject to refund                                                         |       | 4,373,000        |       | 203,000 |   |
| Excess recovery of costs related to  transfer of Certificate of Convenience and Necessity |       | 723,000          |       | 704,000 |   |
|                                                                                           |            |                  |            |  |  |  |  |

 

The Company will be allowed to recover certain rate case costs over aperiod mandated by the PUCT.  Any costsnot allowed for recovery will be expensed immediately.  A decision from the PUCT concerning theamount and period of recovery is expected in June 2005.

 

Both regulatory liabilities are expected to be refunded to customerswithin 12 months.

 

**Earnings Per Share**

 

Basic earnings per common share is computed by dividing net income bythe weighted average number of common shares outstanding.  Diluted earnings per common share is computedby dividing net income by the weighted average number of common shares plus thedilutive impact of stock options, warrants and deferred compensationarrangements which were outstanding during the period calculated by thetreasury stock method.

 

**Cash and Cash Equivalents**

 

The Company considers all unrestricted highly liquid investmentspurchased with original maturities of three months or less to be cashequivalents. The carrying amount of cash equivalents approximates market valuedue to the short-term maturity of these investments.

 

**Restricted Cash Investment**

 

At December 31, 2003, the Company was required to maintain a restrictedcash investment of $14,169,000 which served as collateral for the initialadvance from Beal Bank S.S.B.   Terms ofthe loan agreement provided for investment of the cash collateral only incertain specified types of investments. Interest earned was not restricted, and was not classified asrestricted.   The initial advance wasrepaid in November 2004, with funds from the collateralized restricted cashinvestment used to satisfy the debt payment. See Note 13.

 

**Allowance for Doubtful Accounts**

 

The Company provides an allowance for doubtful accounts receivable thatare estimated to be uncollectible based on historical trends for each rateclass.  As of December 31, 2004 and 2003,the allowance for doubtful accounts was $115,000 and $78,000, respectively. Baddebt expense for the years ended December 31, 2004, 2003 and 2002, was$143,000, $113,000 and $120,000, respectively.

 

F-9

----

 

**Inventories**

 

Although the Company utilizes an independent third party for its materialswarehousing function, inventories owned and on hand are primarily transmissionparts and materials which are not normally stocked by the warehousing company;supplies and materials maintained on service trucks; and materials at variousremote field locations.  Inventories arevalued at historical cost, at the lower of cost or market.

 

**Investments and Notes Receivable**

 

The Company accounts for its investments under the cost basis method ofaccounting if the investment is less than 20% of the voting stock of theinvestee, or under the equity method of accounting if the investment is greaterthan 20% of the 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.

 

An investment is considered impaired if the fair value of theinvestment is less than its cost. Generally, an impairment is considered other-than-temporary unless (i)the Company has the ability and intent to hold an investment for a reasonableperiod of time sufficient for an anticipated recovery of fair value up to (orbeyond) the cost of the investment; and (ii) evidence indicating that the costof the investment is recoverable within a reasonable period of time outweighsevidence to the contrary.  If impairmentis determined to be other-than-temporary, then an impairment loss is recognizedequal to the difference between the investment’s cost and its fair value.

 

The Company has investments in associated organizations that relateprimarily to required membership certificates and accumulated capitalallocations, all of which are accounted for using the cost method ofaccounting.  Capital allocations for thetwo primary investees, National Rural Utilities Cooperative Finance Corporation(“CFC”) and Texas Electric Cooperative, Inc. (“TEC”), are determined annuallyby the respective organizations based on their bylaws, operating margins, cashpositions and various other factors.  TheCompany recognizes capital allocations from the respective organization asincome when it is declared by each respective organization.  CFC is the Company’s primary lender and TECprovides various lobby services for electric cooperatives in Texas.

 

**Utility Plant**

 

Utility plant is stated at the original cost of construction, includingdirect labor, materials, contracted services, payroll taxes and related payrollburdens, and overhead.  Contributions inaid of construction are credited to the applicable utility plant accounts.  Gains or losses resulting from retirements orother dispositions of utility property in the normal course of business arecredited or charged to the accumulated provision for depreciation.  The cost of maintenance, repairs and minorreplacements are charged to operations as incurred.  The Company does not accrue any cost inadvance for major maintenance or repair projects or the cost of removal.

 

F-10

----

 

Depreciation is provided on the following annual rates:

 
| Transmission plant         |   | 3.1% - 10 | %      |
|----------------------------|--------|-----------|--------|
| Distribution  plant        |   | 3.1       | %      |
| General  plant:            |   |      |   |
| Structure and improvements |   | 2.5% - 10 | %      |
| Transportation             |   | 33        | %      |
| Equipment                  |   | 33        | %      |
| Other                      |   | 1.4% - 2  | %      |
| Software costs             |   | 20        | %      |

 

**Nonutility Property**

 

Nonutility property is real estate, primarily an office building, andinvestments in real estate partnerships not principally used in the Company’score business of electric distribution.   Prior to their sale in February 2004, the Company’s limited partnerinvestment in real estate partnerships was included also.  All nonutility property except real estatepartnerships is stated at original cost. Maintenance, repairs and miscellaneousreplacements and renewals of this type of nonutility property are charged tooperations as incurred. The majority of depreciation is provided on a straightline basis over estimated useful lives, which range from 15 to 30 years.

 

Income and expenses related to the Company’s primary real estateproperty are recognized on an accrual basis. The investments in real estate partnerships were accounted for under thecost basis method of accounting because the Company’s ownership was less than10% in each case.  Income from theCompany’s miscellaneous real estate partnership investments is recognized asincome was received.   These investmentswere sold in February 2004.

 

**Impairment of Long-Lived Assets**

 

The Company’s policy is in accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” whereby long-lived assetsare reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.  Recoverability of assets to be held and usedis measured by a comparison of the carrying amount of an asset to estimatedundiscounted future cash inflows expected to be generated by the asset.  If the carrying amount of an asset exceedsits estimated undiscounted future cash flows, an impairment charge isrecognized for the amount by which the carrying amount exceeds the fair valueof the asset.

 

**Goodwill and Intangible Assets**

 

Goodwill is reviewed annually as of December 31 for impairment orwhenever events and changes in circumstances occur that may reduce the fairvalue below the carrying value.  Noimpairment has been necessary because the fair value of the recorded goodwillhas exceeded the carrying value.

 

In connection with the conversion in 2002 of the line of credit withCFC into a long term mortgage note, the Company was required to pay aconversion fee.  This is being amortizedover the life of the new debt, which is 6 years.

 

The Company capitalized costs it incurred in connection with thefinancing arrangements with Beal Bank S.S.B. The terms of the initial advance with the bank provided for a due dateof September 9, 2004, and because it was not certain that the Company woulddraw on the additional advance, the financing costs were being amortized overthe 12 month period of the initial advance.  The initial advance was repaid in November  2004.  See also Note 13.

 

F-11

----

 

The Company has other miscellaneous intangible assets that are notdeemed to have indefinite lives.  Theseassets will continue to be amortized over their estimated useful lives, whichrange from 3 to 10 years.  See Note 11.

 

**Capitalized Interest**

 

The Company capitalizes interest cost to construction work in progresscalculated in accordance with SFAS No. 34, “Capitalization of Interest Cost.”

 

**Equities and Margins of the Cooperative**

 

As of December 31, 2001, the Cooperative’s equities and marginsconsisted only of amounts that were obligated to be converted into shareholderequity.

 

**Revenue Recognition**

 

For all periods through December 31, 2002, the Company recorded revenueon the basis of meters read and billed to customers.  This was pursuant to the rate-making policyas set by the Company’s Board of Directors. The accrual method recognizes revenue when the service and power havebeen delivered to the customer.  Had theCompany recorded revenue on an accrual basis, a regulatory liability would haveexisted because it was not entitled to recognize revenue until the customershad been billed.  In the utilityindustry, the rate-making policy defines the accounting requirements accordingto SFAS No. 71.

 

Effective January 1, 2003, the Company’s Board of Directors revised therate-making policy to recognize unbilled revenue.  Therefore, the Company was required to changeaccounting principles.  Under the new rate-makingstructure, the Company records revenue based on amounts billed to customers aswell as unbilled amounts based upon an estimate of the revenues for energy andservice delivered since the latest billing through the end of the period.  The effect of the change for 2003 was toincrease electric revenues by $3,400,000, and increase purchased power by$1,318,000, for a net increase in income before income taxes of $2,082,000.Unrecognized, unbilled electric revenues as of December 31, 2002, were approximately$2,521,000, respectively.

 

Other operating revenue consists primarily of fees from customers foritems such as late payment penalties and connection services, as well asbuilding rental income which is accrued monthly based on contractual lease obligations.

 

**Purchased Power Costs**

 

The Company accrues its purchased power cost based on actual usage forthe respective period.

 

The Company’s current tariffs for electric service include power costrecovery clauses under which electric rates charged to retail customers areadjusted monthly to collect actual purchased power costs incurred in providingservice. The over or under collection is reflected in the balance sheet asPurchased power subject to recovery or refund. In connection with its review of the Company’s proposed tariffs forretail service, the PUCT may require the Company to change to a fixed fuelfactor method for billing customers, subject to annual reconciliations ofactual power cost incurred to actual fuel revenues collected.

 

In September 2001, the Company determined that approximately $1,700,000of collected power recovery costs subject to refund represented billable coststo customers and as a result, recorded an adjustment to reduce purchased powercosts and the purchased power subject to refund account. This amount wasreflected in the power recovery costs subject to refund liability.  In January 2002, the Company determined thatapproximately

 

F-12

----

 

$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, purchased power costs subject torecovery, and a regulatory liability, deferred revenue.

 

During the rate case proceedings in the fall of 2004, the Companydetermined that power costs of $3,074,000 had been overcollected under theCompany’s retail tariffs through the power cost recovery process.  A regulatory liability was recorded for thisovercollection, and the over recovery was disclosed to the PUCT.  These monies are currently being returned tocustomers through power cost recovery refunds. As of December 31, 2004, $480,000 had been returned to customers.   Legal issues regarding this over recoveryand the method and timing of refunding it are being discussed with the PUCTStaff, and the ultimate outcome is unknown. In addition, the Company believes rate case costs of $3,593,000 will befully allowed, and this recovery will also offset the power cost recoveryovercollection, making the payout to customers cash neutral, with no economiceffect to the Company’s statement of operations.  However, this is also subject to PUCTapproval.  See Note 23.

 

**Stock Based Compensation**

 

Effective January 1, 2003, the Company adopted the fair value method ofaccounting for its employee stock incentive plan in accordance with SFAS No.123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accountingfor 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 fair valuemethod been originally applied.  See alsoNote 16.

 

**Income Taxes**

 

The Company accounts for income taxes under the asset and liabilitymethod of accounting for income taxes. Under this method, deferred income taxes are recognized for theestimated future tax consequences of “temporary differences” by applyingenacted statutory tax rates for each taxable jurisdiction applicable to futureyears to differences between the financial statement carrying amounts and thetax basis of existing assets and liabilities. The Company records a valuation allowance to reduce its deferred taxassets to the extent it is more likely than not that such deferred tax assetswill not be realized.  The effect ondeferred tax assets and liabilities of a change in tax rate is recognized inincome in the period that includes the enactment date.

 

**Derivative Instruments**

 

The Company may use derivative instruments to manage the natural gascomponent of power costs, which minimize the fluctuations in customers’ powerbills.  All payments made or received inconnection with these types of transactions will be collected from or rebatedto customers through the power cost recovery component of the customers’ powerbills.  The fair market value of theseinstruments is recorded as an asset or liability with a correspondingregulatory liability or regulatory asset, as all amounts paid or received willbe passed through to the Company’s customers. As of December 31, 2004 or 2003, no derivative position was held.

 

**New Accounting Standards**

 

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.”  SFAS No. 123R revises SFAS No. 123, “Accountingfor Stock-Based Compensation.”  This newstandard generally requires the cost associated with employee services receivedin exchange for an award of equity instruments be measured based on the grant-

 

F-13

----

 

date fair value of the award and recognized in the financial statementsover the period during which the employee is required to provide services inexchange for the award.  SFAS No. 123Ralso provides guidance on how to determine the grant-date fair value for awardsof equity instruments, as well as alternative methods of adopting itsrequirements.  SFAS No. 123R is effectiveas of the beginning of the first interim or annual reporting period after June15, 2005, and applies to all outstanding and unvested share-based paymentawards at a company’s adoption date.  TheCompany changed its method of accounting from the intrinsic method per APBOpinion No. 25, to the fair value method per SFAS No. 148, effective January 1,2003.  Therefore, SFAS No. 123R is notexpected to have an impact on the Company’s consolidated financial statements.

 

In May 2004, the Financial Accounting Standards Board issued StaffPosition No. 106-2, “Accounting and Disclosure Requirements Related to theMedicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP106-2”).   FSP 106-2 permits a sponsor ofa postretirement health care plan that provides a prescription drug benefit tomake a one-time election to defer accounting for the effects of the MedicareAct and requires certain disclosures pending determination as to whether thesponsor’s postretirement health care plan reasonably expect to qualify forbeneficial treatment under the Act.  SeeNote 16 for quantification.

 

**Other Comprehensive Income**

 

There were no items of comprehensive income for any period presented.

 

**Reclassifications**

 

Certain reclassifications have been made to prior periods’ financialstatements to conform to the presentation adopted in the current period.

 

**2. RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS**

 

In connection with the Company’s conversion from an electriccooperative to an investor owned utility, the Company had independentprofessional consultants evaluate the corporate structure of the Company andits subsidiaries.  Based on that review,the Company believed the subsidiary would continue to qualify as a tax exemptcooperative.  Therefore, the Companytreated the subsidiary as exempt for both financial and tax reportingpurposes.  Recently, in connection withan unrelated project, the tax structure of the subsidiary was reviewed andissues arose concerning its exempt status. Because of the complex nature of the issue, the Company is seekingguidance from the Internal Revenue Service regarding the taxable nature of thesubsidiary.  As a result of the Company’sidentification of the issue, on August 24, 2005, Management and the AuditCommittee concluded that the Company would amend and restate its Annual Reporton Form 10-K for the year ended December 31, 2004, to treat the subsidiary as ataxable entity for financial reporting purposes.  The Company had generated net operatinglosses in earlier periods that would be used to offset the taxable nature ofthe subsidiary.  The use of the netoperating losses, earlier than expected, may result in taxes payable that aregreater than originally disclosed.

 

F-14

----

 

Restated amounts as of and for the years ended December 31, 2004, 2003and 2002, are as follows:

 
| ** **                                           | ** ** | **As**                                      | ** ** | ** **      | ** ** | **As**       | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|-----------------|------------|--------------|------------|
| ** **                                           | ** ** | **Reported**                                | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
| ** **                                           | ** ** | **(In thousands except per share amounts)** | ** ** |
|                                                 |       |                                        |       |            |       |         |       |
| **As of and for the year ended December 31,  2004:** |       |                                        |       |            |       |         |       |
| Balance sheet:                                       |       |                                        |       |            |       |         |       |
| Net deferred tax asset                               |       | $                                           | 3,285      |            | $          | (3,285       | )          | $ | — |   |
| Valuation allowance for deferred tax asset           |       | (3,285                                      | )          | 3,285           |       | —       |       |
| Current income tax payable                           |       | —                                      |       | 633             |       | 633          |       |
| Net deferred tax liability                           |       | —                                      |       | 1,275           |       | 1,275        |       |
| Statement of operations:                             |       |                                        |       |            |       |         |       |
| Income tax expense (benefit)                         |       | (2,140                                      | )          | 1,908           |       | (232         | )          |
| Net income                                           |       | 5,433                                       |       | (1,908          | )          | 3,525        |       |
| Net income per common share:                         |       |                                        |       |            |       |         |       |
| Basic                                                |       | 3.51                                        |       | (1.23           | )          | 2.28         |       |
| Diluted                                              |       | 3.40                                        |       | (1.19           | )          | 2.21         |       |
| Statement of cash flows:                             |       |                                        |       |            |       |         |       |
| Net cash provided by operating activities            |       |                                        |       |            |       |         |       |
| Other assets/deferred credits                        |       | 1,617                                       |       | 1,275           |       | 2,892        |       |
| Income tax receivable                                |       | (3,986                                      | )          | 633             |       | (3,353       | )          |
| Net cash flows used in investing activities          |       | (4,006                                      | )          | —          |       | (4,006       | )          |
| Net cash flows used in financing activities          |       | (8,544                                      | )          | —          |       | (8,544       | )          |
|                                                 |       |                                        |       |            |       |         |       |
| **As of and for the year ended December 31,  2003**  |       |                                        |       |            |       |         |       |
| Balance sheet:                                       |       |                                        |       |            |       |         |       |
| Deferred tax asset                                   |       | 8,074                                       |       | (2,834          | )(a)       | 5,240        |       |
| Valuation allowance for deferred tax asset           |       | (8,074                                      | )          | 2,834           | (a)        | (5,240       | )          |
|                                                 |       |                                        |       |            |       |         |       |
| **As of and for the year ended December 31,  2002**  |       |                                        |       |            |       |         |       |
| Balance sheet:                                       |       |                                        |       |            |       |         |       |
| Deferred tax asset                                   |       | 9,717                                       |       | (1,064          | )          | 8,653        |       |
| Valuation allowance for deferred tax asset           |       | (9,717                                      | )          | 1,064           |       | (8,653       | )          |
|                                                      |            |                                             |            |                 |            |              |            |  |  |  |

 

----

(a)No net change to the statement of operations.

 

**3. CORPORATE CONVERSION**

 

On October 20, 1998, the Cooperative’s members adopted a conversionplan to reorganize the Cooperative from a member owned electric cooperative toa shareholder owned business corporation.  In connection with the conversion plan, Cap Rock Energy Corporation wasformed in December 1998 as a subsidiary of the Cooperative and substantiallyall of the Cooperative’s operational activities were transferred toEnergy.  Energy registered shares of itscommon stock with the Securities and Exchange Commission as of February 8,2002, and they were distributed to the Cooperative’s members and holders ofequity accounts that chose that option. On March 14, 2002, the common stock ofEnergy was approved for listing on the American Stock Exchange. See Note 4concerning the Company’s related repurchase offer.  The Cooperative was then dissolved in March2004.

 

F-15

----

 

Energy’s Articles of Incorporation provide that any shareholder oraffiliate of a shareholder holding in excess of 5% of Energy’s outstandingcommon stock will have its voting rights for those shares in excess of 5%reduced to 1/100 per share.

 

**4. 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 to purchaseall shares tendered.   The Company’soriginal purchase commitment was only to those shareholders who were the original holders of record, and who hadheld those shares continuously until the first anniversary of the distributionof 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 the Company at$10 per share, totaling $821,400.  AtDecember 31, 2003, such amount is shown in Treasury stock within theStockholders’ Equity section of the consolidated balance sheet.  There are no further obligations related tothe Company’s repurchase commitment.

 

**5. UNSUCCESSFUL LAMAR ACQUISITION**

 

In October 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 allowable exceptions,Lamar was required to reimburse the Cooperative for all costs and expenses ithad incurred, whether paid to outside parties or incurred internally, withrespect to the combination.  Thecompletion of the combination was delayed because of litigation with Lamar’spower supplier. The power supplier claimed that Lamar and the Cooperative hadeach breached various agreements.

 

On August 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.

 

Lamar terminated the Combination Agreement in October 2002 and theManagement Service Agreement in November 2002. Lamar filed suit against the Company seeking a declaratory judgment thatit had the right to terminate both agreements without regard to payment of anykind to the Company.   The Companybelieves that Lamar’s stated reason for termination of the CombinationAgreement does not fall within the specific allowable exceptions set forth inthe agreement, and therefore the Company believes it is entitled toreimbursement of all costs and expenses incurred.  The Company is also seeking the specifiedliquidated damages fee of $300,000 in connection with the termination of theManagement Service Agreement.

 

Because Lamar terminated the Combination Agreement, generally acceptedaccounting principles required the impairment of previously capitalized coststhat were incurred in connection with the combination.  The majority of these costs were outsidelegal and consulting fees.  At December31, 2002, these costs, aggregating $1,357,000, were expensed and are shown on the consolidated statement ofoperations.

 

F-16

----

 

**6. EARNINGS PER SHARE INFORMATION**

 

The following table shows the reconciliation of basic and dilutedearnings per share:

 
| ** **                                                            | ** ** | **YEAR ENDED DECEMBER 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                            | ** ** | **Income**                       | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                            | ** ** | **(In Thousands)**               | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| ** **                                                            | ** ** | **(Restated)**                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic  earings per share:                                             |       |                             |       |   |   |   |   |
| Income from continuing operations available  for common stock         |       | $                                | 3,525      |   | 1,546,271 |   | $ | 2.28 |   |
|                                                                  |       |                             |       |   |   |   |   |
| Effect of  diluted securities:                                        |       |                             |       |   |   |   |   |
| Shares that have been deferred under the  Stock for Compensation plan |       |                             |       | 50,525 |   | (0.07 | ) |
| Diluted  earnings per share:                                          |       | $                                | 3,525      |   | 1,596,796 |   | $ | 2.21 |   |

 
| ** **                                                            | ** ** | **YEAR ENDED DECEMBER 31, 2003** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                            | ** ** | **Income**                       | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                            | ** ** | **(In Thousands)**               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic  earings 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 |   | (0.28 | ) |
| Diluted  earnings per share:                                          |       | $                                | 11,198     |   | 1,510,741 |   | $ | 7.41 |   |

 

Both basic and diluted earnings per share for the year ended December31, 2002, are not materially different.

 

**7. OTHER CURRENT ASSETS**

 

Other current assets as of December 31, 2004 and 2003, consisted of thefollowing (in thousands):

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|------------------|------------|
| ** **                 | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                       |       |             |       |   |   |
| Inventories                |       | $                | 1,333      |   | $ | 939 |   |
| Prepaid  income tax        |       | 3,398            |       | — |   |
| Prepaid  insurance         |       | 363              |       | 385 |   |
| Interest  receivable       |       | 91               |       | 67 |   |
| Other                      |       | 246              |       | 196 |   |
| Total Other Current Assets |       | $                | 5,431      |   | $ | 1,587 |   |

 

F-17

----

 

**8. INVESTMENTS AND NOTES RECEIVABLE**

 

Investments and notes receivable as of December 31, 2004 and 2003,consisted of the following (in thousands):

 
| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|------------------|------------|
| ** **                                           | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                                                 |       |             |       |   |   |
| Investments  in associated organizations:            |       |             |       |   |   |
| CFC capital term certificates                        |       | $                | 5,905      |   | $ | 6,210 |   |
| CFC patronage capital                                |       | 2,569            |       | 2,543 |   |
| TEC patronage capital and bonds                      |       | 852              |       | 852 |   |
| Other                                                |       | 41               |       | 49 |   |
| Total investments in associated  organizations       |       | 9,367            |       | 9,654 |   |
|                                                 |       |             |       |   |   |
| Investment  in United Fuel (Note 14)                 |       | —           |       | 360 |   |
| Note  receivable related to United Fuel stock        |       | 1,300            |       | — |   |
| Note  receivable related to real estate partnerships |       | 286              |       | — |   |
| Other  investments                                   |       | 51               |       | 31 |   |
| Total Investments and Notes Receivable               |       | $                | 11,004     |   | $ | 10,045 |   |

 

Allocations of income from all associated organizations was $540,000,$530,000 and $478,000, respectively, for the years ended December 31, 2004,2003 and 2002.

 

In October 2003, the Company sold its 42% interest in Map Resources,Inc. (“MAP”) to MAP in exchange for a note receivable of $1,250,000, dueOctober 8, 2004, with interest at 6% per annum. The original investment had been accounted for using the equitymethod.  The note receivable, shown inCurrent Notes Receivable at December 31, 2003, was collateralized by theoriginal stock.  The investmentappreciated over the period that the Company held it, but because the salesprice was less than the recorded book value on an equity method basis, theCompany was required to reflect a loss of $1,056,000 for 2003.  The note was repaid in July 2004, and theCompany recouped its original cash investment. The Company’s equity earnings in MAP for the nine month period endedSeptember 30, 2003, and the year ended December 31, 2002, was $144,000 and$115,000, respectively.

 

In March 2004, the Company signed an agreement with a shareholder ofUnited Fuel and Energy Corporation (“United Fuel”) to sell its shares of stockin that company for a sales price of $1,300,000 in exchange for a notereceivable.  The terms of the agreementprovide:  (a) interest on the notereceivable at 6% annum, (b) payment of $500,000 on the payment date plusaccrued interest, (c) payment of the remaining principal balance in three equalannual installments plus accrued interest beginning one year after the paymentdate.  The payment date is defined as thesooner of 24 months from the date of the agreement or 60 days after United Fuelhas completed certain capitalization arrangements.  Recognition of the gain of $940,000 has beendeferred until principal payments have been received.  See Note 17. All conditions required pursuant to the agreement have been satisfied,and the Company expects payment as scheduled in 2005.

 

The Company sold its limited partner interest in real estatepartnerships in February 2004, to an unrelated third party in exchange for anote receivable of $286,000 due 2009, with interest at 4.5% per annum.  The note is collateralized by the partnershipinterests.  See Note 10.

 

F-18

----

 

**9. UTILITY PLANT**

 

Utility plant as of December 31, 2004 and 2003, consisted of thefollowing (in thousands):

 
| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|------------------|------------|
| ** **                           | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                                 |       |             |       |   |   |
| Distribution  facilities             |       | $                | 184,713    |   | $ | 179,250 |   |
| Transmission  facilities             |       | 65,792           |       | 69,051 |   |
| General  facilities                  |       | 9,816            |       | 9,045 |   |
| Total utility plant                  |       | 260,321          |       | 257,346 |   |
| Less accumulated depreciation        |       | (111,466         | )          | (105,349 | ) |
| Total  utility plant in service, net |       | 148,855          |       | 151,997 |   |
| Construction  work in progress       |       | 506              |       | 165 |   |
| Total Utility Plant, net             |       | $                | 149,361    |   | $ | 152,162 |   |

 

As of December 31, 2004 and 2003, all utility plant assets, except thetransmission facilities, are pledged to collateralize debt and capital leaseobligations.

 

**10. NONUTILITY PROPERTY**

 

Nonutility property as of December 31, 2004 and 2003, consisted of thefollowing (in thousands):

 
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|------------------|------------|
| ** **                     | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                           |       |             |       |   |   |
| Real estate                    |       | $                | 1,992      |   | $ | 2,278 |   |
| Furniture,  fixtures and other |       | 7                |       | 7 |   |
| Total nonutility property      |       | 1,999            |       | 2,285 |   |
| Less accumulated depreciation  |       | (772             | )          | (740 | ) |
| Total Nonutility Property, net |       | $                | 1,227      |   | $ | 1,545 |   |

 

The Company owns a 45,000 square foot office building that is used asits general corporate headquarters. The Company currently occupiesapproximately 35% of the building and the remainder is leased to commercialtenants, subject to leasing terms ranging from monthly to 7 years. For theyears ended December 31, 2004, 2003 and 2002, third party building rentalrevenue was $294,000, $258,000 and $286,000, respectively. Building rentalrevenues, which are not material to the Company’s operations, for each of thenext five years are expected to be approximately $250,000 per year. As ofDecember 31, 2004 and 2003, the net book value of the building and relatedproperty was $1,112,000 and $1,141,000, respectively, which is the majority ofthe nonutility property.

 

The Company sold its limited partner interest in real estatepartnerships in February 2004, to an unrelated third party in exchange for anote receivable of $286,000 which was collateralized by the partnershipinterests.  There was no gain or lossrecorded on the sale.  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 partnership interests also involvedthe transfer of those guarantees to the buyer. Income for each period shown related to the real estate partnerships hasbeen less than $12,000.

 

F-19

----

 

**11. REGULATORY AND OTHER ASSETS**

 

Other assets as of December 31, 2004 and 2003, consisted of thefollowing (in thousands):

 
| ** **                                        | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|------------------|------------|
| ** **                                        | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                                              |       |             |       |   |   |
| McCulloch  goodwill, net of amortization          |       | $                | 199        |   | $ | 199 |   |
| Bank fees,  net of amortization (Notes 12 and 13) |       | 134              |       | 846 |   |
| Rate case  costs                                  |       | 3,593            |       | 145 |   |
| Total Other Assets and Deferred Charges           |       | $                | 3,926      |   | $ | 1,190 |   |

 

The McCulloch goodwill represents costs incurred in connection with theacquisition of an electric cooperative in 1999, in the amount of $373,000.  As of December 31, 2004 and 2003, theaccumulated amortization was $174,000.

 

Bank fees are costs of $210,000 incurred in connection with theconversion of the line of credit to a mortgage note.  Accumulated amortization at December 31, 2004and 2003, is $76,000 and $30,000.  As ofDecember 31, 2003, bank fees also included costs of $999,000 related to therefinancing of the transmission system with Beal Bank, S.S.B., with associatedaccumulated amortization of $333,000. These costs were fully amortized and retired because the loan waseffectively repaid in November 2004.  Seealso Notes 12 and 13.

 

Rate case costs are third party costs incurred to prepare the ratefiling package, as well as the public hearing process.  These costs are regulatory assets because theamount and period over which the Company will be allowed to recover these costswill be mandated by the PUCT.  The PUCTis expected to rule on this matter in June 2005.  See Note 23.

 

**12. MORTGAGE NOTES AND LINE OF CREDIT**

 

The CFC notes have been issued in conjunction with a Second RestatedMortgage and Security 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%.

 

In conjunction with the conversion from a member owned cooperative to ashareholder owned corporation, CFC waived the 20% equity to total assets ratiorequirement as it concerned the conversion, consented to the distribution ofcash and electric credits to former members, waived the 1.35 debt service coverageratio requirement as it concerned the conversion, and notified the Company thatall existing CFC indebtedness may remain in place with CFC after theconversion.

 

Substantially all of the CFC mortgage notes are subject to interestrate repricing at the end of various periods, at the Company’s option.  Mortgage notes with CFC as of December 31,2004 and 2003, consisted of the following (in thousands):

 

F-20

----

 
| ** **                                                                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                     | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                                                                                           |       |             |       |   |   |
| Interest at 3.35% at December 2002 and  2003, with interest repricing in January 2004 and 2005 |       | $                | —     |   | $ | 10,400 |   |
| Interest at  4.20% with interest repricing in January 2005                                     |       | —           |       | 69,109 |   |
| Interest at  4.70% with interest repricing in January 2006                                     |       | 33,017           |       | 34,128 |   |
| Interest at  4.85% with interest repricing in January 2006                                     |       | 6,467            |       | — |   |
| Interest at  4.50% with interest repricing in January 2007                                     |       | 5,960            |       | 6,080 |   |
| Interest at  5.15% with interest repricing in January 2007                                     |       | 64,055           |       | — |   |
| Interest at  4.30%                                                                             |       | 27,872           |       | 28,000 |   |
| Interest at  fixed rates:                                                                      |       |             |       |   |   |
| 4.20%                                                                                          |       | 3,590            |       | — |   |
| 7.00%                                                                                          |       | 2                |       | 2 |   |
| Variable  rate                                                                                 |       | 2,791            |       | — |   |
|                                                                                           |       | 143,754          |       | 147,719 |   |
| less current maturities                                                                        |       | (9,881           | )          | (4,531 | ) |
| Total Mortgage debt, net of current portion                                                    |       | $                | 133,873    |   | $ | 143,188 |   |

 

The Company has capitalized, as a part of utility plant, the cost ofborrowed funds used for financing construction. Capitalized interest for theyears ended December 31, 2004, 2003 and 2002, was $21,000, $7,000 and $12,000,respectively.  The rate used for interestcharged to construction is the Company’s effective borrowing rate.

 

Annual maturities of the mortgage notes as of December 31, 2004, are asfollows (in thousands):

 

| 2005                 |   | $      | 9,881   |   |
|----------------------|--------|--------|---------|--------|
| 2006                 |   | 3,653  |    |
| 2007                 |   | 30,032 |    |
| 2008                 |   | 3,378  |    |
| 2009                 |   | 3,525  |    |
| Thereafter           |   | 93,285 |    |
|                 |   |   |    |
| Total  mortgage debt |   | $      | 143,754 |   |

 

F-21

----

 

**13. TRANSMISSION SYSTEM FINANCING**

 

In connection with the original financing and construction of itstransmission line, the Company entered into agreements qualified as capitallease obligations.  As a result, thetransmission line, substation assets and associated capital lease obligationswere recorded on the Company’s consolidated financial statements.

 

The original cost of the transmission facility and costs related toconsummation of the lease agreements totaled $61,999,000, and were beingrecovered from customers through power cost billings over a ten yearperiod.  Consistent with this ratemakingtreatment, the transmission facilities and capital lease obligation were beingamortized over the same ten year period, with that period ending September 30,2003. The monthly lease payments included an amount for a sinking fund, whichwas to be used to reduce the amount of the final balloon payment on the capitallease, which was due September 2003.

 

Regularly scheduled monthly principal payments on the transmissionsystem capital lease obligation for the nine months ended September 30, 2003,and the year ended December 31, 2002, were approximately $3,556,000 and $5,047,000,respectively.  The correspondingamortization of property and equipment under the capital lease was credited toaccumulated depreciation and amortization accounts for the transmissionfacilities consistent with ratemaking treatment.  Interest on the capital lease obligations forthe nine months ended September 30, 2003, and the year ended December 31, 2002,was approximately $847,000 and $1,443,000, respectively, and is classified aspurchased power cost consistent with ratemaking treatment.

 

FERC approval was received in August 2003 for NewCorp to borrow$31,500,000 from Beal Bank S.S.B. (“Beal Bank”).  The initial advance of $14,169,000 was usedfor payment of the balloon payment on the transmission system capital lease inSeptember 2003.  Simultaneously, thesinking fund of $8,207,000 was released by the lessee, and used to partiallyfund a restricted securities account of $14,169,000, which was the only assetcollateralized by Beal Bank.

 

Interest on the Beal Bank loan was 10.75%, payable monthly.  The financing arrangement provided for acommitment fee, which totaled $457,000 for the initial advance.  Additional amounts paid to Beal Bank werereimbursement of expenses, attorney fees, appraisals and consulting, which atDecember 31, 2004, aggregated $1,184,000. Prepayment of the initial advance was not allowed unless an additionaladvance was funded before the September 9, 2004, due date.  In the accompanying consolidated balancesheet at December 31, 2003, the initial advance of $14,169,000 is shown incurrent liabilities because it was not certain that the Company would draw onthe additional advance from Beal Bank. Two amendments to the financing agreement were executed which extendedthe due date of the initial advance.  Thecollateralized cash investment was then used to repay the initial advance inNovember 2004.

 

**14. NOTE PAYABLE AND OTHER CAPITAL LEASES**

 

Previously, the Company had a note payable to a bank that wascross-collateralized by a note receivable from United Fuel and Energy Corporation(“United Fuel”).  In October 2003, UnitedFuel consummated financing with a lender that provided for funds to partiallypay down the Company’s note payable to a bank, with United Fuel taking theposition as borrower on the Company’s note payable to a bank, thusextinguishing United Fuel’s note receivable to the Company.  The Company was no longer a borrower and itsinvolvement had been reduced to being a secondary guarantor for United Fuel’snote of $3,500,000.  Generally acceptedaccounting principles required the Company to record a guarantee obligationthat was measured at fair value.  Aguarantee obligation of $35,000 was recorded, based on factors such as assetcollateralization value and guarantor hierarchy.  United Fuel repaid the note in November 2004,effectively releasing the Company’s guaranty and the recorded guaranteeobligation was then eliminated.

 

F-22

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The Company has other miscellaneous capital leases for certainequipment used in operations, with such equipment included in utility plant onthe balance sheet.  Future minimum leasepayments are as follows (in thousands):

 
| 2005                            |   | $  | 110    |   |
|---------------------------------|--------|----|--------|--------|
| 2006                            |   | 57 |   |
| 2007                            |   | 18 |   |
| Total capital lease obligations |   | $  | 185    |   |

 

**15. ACCRUED AND OTHER CURRENT LIABILITIES**

 

Accrued and other current liabilities at December 31, 2004 and 2003,consisted of the following (in thousands):

 
| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|------------------|------------|
| ** **                                       | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                                             |       |             |       |   |   |
| Accrued  taxes                                   |       | $                | 18         |   | $ | 18 |   |
| Accrued  interest                                |       | 516              |       | 520 |   |
| Accrued  payroll and employee benefits (Note 16) |       | 914              |       | 1,670 |   |
| Regulatory  liability                            |       | 723              |       | 704 |   |
| Customer  deposits and prepayments               |       | 778              |       | 760 |   |
| Accrued  other                                   |       | 253              |       | 230 |   |
| Total Accrued and Other Current Liabilities      |       | $                | 3,202      |   | $ | 3,902 |   |

 

**16. EMPLOYEE BENEFIT PLANS**

 

**Executive Deferred Compensation Plans**

 

In November 2002, the Board approved an Executive Deferred CompensationRetirement Plan whereby management, members of the Board of Directors andcertain highly compensated employees could defer a portion of theircompensation pursuant to the terms of the plan. The Company may also make contributions to the plan on behalf of theindividuals participating in the plan.  Aparticipant is 100% vested in contributions he may make to the plan, withCompany contributions vesting at 10% per year for the first four years, and 20%per year for the next three years.  TheCompensation Committee of the Board of Directors administers the plan.  For the years ended December 31, 2004 and2003, $18,000 and $16,000 were contributed to the plan, and such amounts areshown as a liability on the consolidated balance sheets.

 

**Stock Incentive Plan**

 

The Company has a Stock Incentive Plan, approved by the shareholders,that provides for the granting of awards of common stock, options to purchasecommon stock, both restricted and unrestricted, and certain related rights toeligible officers, employees and directors of the Company.  The plan will continue in effect untilDecember 31, 2013.  The Stock IncentivePlan provides for a maximum of 800,000 shares of the Company’s common stock tobe used for stock awards and the granting of options.  Shares of common stock used to satisfy suchawards will be acquired by the Plan either through open market purchases orthrough the issuance of additional common stock.  For the years ended December 31, 2004, 2003and 2002, the Company recorded compensation expense of $4,925,000, $2,133,000and $30,000, respectively, in connection with the fair value of these awards ofcommon stock, of which $934,000, $132,000 and $0, respectively, were in theform of shares withheld by the Company, in order to remit cash payments foremployees’ payroll tax withholding.

 

F-23

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**Employee Stock Purchase Plan**

 

The Company has an Employee Stock Purchase Plan (“ESPP”), also approvedby the shareholders, that provides its employees with the opportunity topurchase shares of its common stock through payroll deductions.  It is the Company’s intention to have theESPP qualify as an employee Stock Purchase Plan under Section 423 of theInternal Revenue Code of 1986, as amended. The Employee Stock Purchase Plan provides for a maximum of 150,000shares.  As of December 31, 2004, the ESPPhad not been implemented.

 

**Stock for Compensation Plan**

 

The Company has a Stock for Compensation Plan (“SCP”) that provides ameans for eligible employees and directors to receive shares of the Company’scommon stock or restricted share units in lieu of cash compensation.  This plan was also approved by theshareholders.  The SCP provides for amaximum of 500,000 shares of the Company’s common stock to be used inconjunction with this plan.  For theyears ended December 31, 2004, 2003 and 2002, cash bonuses of $6,000, $6,000and $367,000, respectively, had been earned by individuals, who then wereawarded shares of stock in lieu of the cash compensation.

 

**Defined Contribution Plan**

 

The Company has a 401(k) plan for employees who meet certaineligibility requirements.  The planpermits a specified percentage of an employee’s salary to be voluntarilycontributed on a pre-tax basis, with a Company matching feature.  Participants may contribute from two percentof eligible earnings up to the maximum federal limit to various self-directedinvestment funds.  The plan provides forvarious levels of Company matching contributions depending upon the level ofemployee contributions.  Companycontributions aggregated $535,000, $527,000 and $481,000, for the years endedDecember 31, 2004, 2003 and 2002.

 

**Other Postretirement Benefits**

 

The Company provides continued major medical coverage to retiredemployees and their dependents.  The costto maintain such benefits for the years ended December 31, 2004, 2003 and 2002,totaled $235,000, $399,000 and $858,000, respectively.

 

The Medicare Reform Act of 2003 allows employers who sponsor apostretirement health care plan that provides a prescription drug benefit toreceive a subsidy for the cost of providing that drug benefit.  In order for employers to receive the subsidypayment under the Medicare Reform Act, the value of the offered prescriptiondrug plan must be at least actuarially equivalent to the standard prescriptiondrug coverage provided under Medicare Part D. The Company’s plan meets the actuarially equivalent test and qualifiesfor the subsidy.  The reduction incurrent period service cost due to the subsidy was $34,000 for the year endedDecember 31, 2004, and the impact on the benefit obligation is $1,562,000.

 

The Company uses December 31 as a measurement date for the plan.

 

F-24

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**Obligations and Funded Status**

 

The following tables set forth the obligations, fair value of planassets and funded status at December 31, 2004 and 2003:

 
| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|------------------|------------|
| ** **                             | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                                   |       |             |       |   |   |
| **Change  in Benefit Obligations**     |       |             |       |   |   |
| Benefit  obligation, beginning of year |       | $                | 3,508      |   | $ | 2,868 |   |
| Service cost                           |       | 245              |       | 206 |   |
| Interest  cost                         |       | 598              |       | 504 |   |
| Participant  contributions             |       | —           |       | — |   |
| Actuarial  loss                        |       | 380              |       | 329 |   |
| Benefit paid                           |       | (653             | )          | (399 | ) |
| Benefit  obligation, end of year       |       | $                | 4,078      |   | $ | 3,508 |   |
|                                   |       |             |       |   |   |
| **Funded  Status**                     |       |             |       |   |   |
| Funded  status - under funded          |       | $                | 11,349     |   | $ | 9,119 |   |
| Unrecognized  net loss                 |       | (7,271           | )          | (5,611 | ) |
| Accrued  benefit cost                  |       | $                | 4,078      |   | $ | 3,508 |   |

 

**Components of Net Periodic Benefit Cost**

 

The following sets forth the components of net periodic benefit costfor the years ended December 31, 2004, 2003 and 2002 (in thousands):

 
| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|------------------|------------|
| ** **                       | ** ** | **2004**         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                             |       |             |       |   |   |   |   |
| Service cost                     |       | $                | 245        |   | $ | 206 |   | $ | 148 |   |
| Interest  cost                   |       | 598              |       | 504 |   | 471 |   |
| Amortization  of experience loss |       | 380              |       | 329 |   | 239 |   |
| Net  periodict benefit cost      |       | $                | 1,223      |   | $ | 1,039 |   | $ | 858 |   |

 

**Actuarial Assumptions and Cost Trends**

 

The following sets forth the assumptions used to determine benefitobligations:

 
| ** **     | ** ** | **DECEMBER 31,** | ** ** |
|----------------|------------|------------------|------------|
| ** **     | ** ** | **2004**         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Discount  rate |       | 5.75             | %          | 6.00 | % | 7.00 | % |

 
| ** **                                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Health care  cost trend rate assumed for next year       |       | 10       | %          | 9        | %          |
| Rate to  which the cost trend rate is assumed to decline |       | 1        | %          | 1        | %          |
| Year that  the rate reaches the ultimate trend rate      |       | 2010     |       | 2008     |       |

 

F-25

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The assumed health care cost trends significantly affect the amountsreported for the post retirement health care liability.  A one percentage point change in assumedhealth care cost trend rates would have the following effects (in thousands):

 
| ** **                                                | ** ** | **One Percentage Point** | ** ** |
|-----------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                | ** ** | **Increase**             | ** ** | **Decrease** | ** ** |
| Effect on  total of service cost and interest cost        |       | $                        | 133        |   | $ | (105 | ) |
| Effect on  accumulated post retirement benefit obligation |       | 1,392                    |       | (1,136 | ) |
|                                                           |            |                          |            |  |  |  |  |

 

**Plan Assets**

 

No return on plan assets was assumed in the calculation as the Companyholds no specified plan assets.

 

**Future Benefit Payments**

 

The following table provides estimates of future benefit payments,which reflect expected future service, as applicable (in thousands):

 
|   |   | 2005      |   | $     | 849    |   |
|--------|--------|-----------|--------|-------|--------|--------|
|   |   | 2006      |   | 838   |   |
|   |   | 2007      |   | 855   |   |
|   |   | 2008      |   | 827   |   |
|   |   | 2009      |   | 776   |   |
|   |   | 2010-2014 |   | 4,019 |   |

 

**17. DEFERRED CREDITS**

 

Deferred credits at December 31, 2004 and 2003, consisted of thefollowing (in thousands):

 
| ** **                                           | ** ** | **DECEMBER 31,** | ** ** |
|------------------------------------------------------|------------|------------------|------------|
| ** **                                           | ** ** | **2004**         | ** ** | **2003** | ** ** |
| ** **                                           | ** ** | **(Restated)**   | ** ** | ** ** | ** ** |
| Post  retirement benefits (Note 16)                  |       | $                | 4,078      |   | $ | 3,508 |   |
| Deferred tax  liability                              |       | 1,275            |       | — |   |
| Deferred  gain on sale of United Fuel Stock (Note 8) |       | 940              |       | — |   |
| Stockholders’  Trust (Note 22)                  |       | 129              |       | — |   |
| Deferred  executive compensation                     |       | 36               |       | 44 |   |
| Unclaimed  member capital credits                    |       | 55               |       | 67 |   |
| Other                                                |       | 56               |       | 58 |   |
| Total Deferred Credits                               |       | $                | 6,569      |   | $ | 3,677 |   |

 

F-26

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**18. FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

The following table presents the carrying amounts and estimated fairvalues of the Company’s financial instruments at December 31, 2004 and2003.  SFAS No. 107 defines the fairvalue of a financial instrument as the amount at which the instrument could beexchanged in a current transaction between willing parties (in thousands):

 
| ** **                  | ** ** | **DECEMBER 31,** | ** ** |
|-----------------------------|------------|------------------|------------|
| ** **                  | ** ** | **2004**         | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **BOOK  VALUE**  | ** ** | **FAIR  VALUE** | ** ** | **BOOK  VALUE** | ** ** | **FAIR  VALUE** | ** ** |
| Cash                        |       | $                | 20,968     |   | $ | 20,968 |   | $ | 12,170 |   | $ | 12,170 |   |
| Restricted  cash investment |       | —           |       | — |   | 14,169 |   | 14,169 |   |
| Notes  receivable           |       | 1,300            |       | 1,300 |   | 1,250 |   | 1,250 |   |
| Mortgage  notes             |       | 143,754          |       | 143,754 |   | 147,719 |   | 147,719 |   |
| Short-term  note payable    |       | —           |       | — |   | 14,169 |   | 14,169 |   |
|                             |            |                  |            |  |  |  |  |  |  |  |  |  |  |

 

The book value of cash and cash equivalents approximated fair valuebecause of the short maturity of those instruments. The carrying values of accountsreceivable and account payable included in the accompanying consolidatedbalance sheets approximated market value at December 31, 2004 and 2003. Asdescribed in Note 12, the Company has both fixed rate and variable rate notes.****The fair value of these mortgage notes isnot able to be readily determined because there is no market for this type ofdebt.

 

**19. MAJOR CUSTOMERS AND SUPPLIERS**

 

For the years ended December 31, 2004, 2003 and 2002, the Company andits subsidiaries had no customer that accounted for more than 10% of operatingrevenues.

 

The Company utilizes an independent third party for its materialswarehousing function.  The terms of thecontract provide that the third party maintain an adequate inventory level ofdistribution type components, with after hours staffing in case ofemergencies.  The Company has alsooutsourced its meter reading function. In the event the contract with the third parties should not be renewed,the Company believes its operations would not be severely affected because newcontracts could be secured at competitive rates and in a timely manner.  See also Note 23, Commitments andContingencies.

 

**20. ELECTRIC DEREGULATION AND CUSTOMER CHOICE**

 

On May 27, 1999, the Texas legislature passed a bill relating to therestructuring of the electric utility industry in Texas. The bill, among otherthings, provided for retail competition to begin on January 1, 2002.Municipally owned utilities and cooperatives could elect, but were notrequired, to offer retail customer choice on or after January 1, 2002.  The Company met the definition of a “cooperative”under this legislation.  On June 22, 2003, the Governor of the State ofTexas signed Senate Bill 1280 into law which became effective September 1,2003.  The definition of “electriccooperative” under the Public Utility Regulatory Act (“PURA”) included a “successorto an electric cooperative created before June 1, 1999, in accordance with aconversion plan approved by a vote of the electric cooperative, regardless ofwhether the successor later purchases, acquires, merges with or consolidateswith, other electric cooperatives.”  SB1280 amended the PURA to treat a successor to an electric cooperative as aninvestor owned utility.  This legislationalso provided for establishment of schedules and procedures by the PublicUtility Commission of Texas for such a successor that was not previouslysubject to regulation as an investor owned utility prior to September 1, 2003,in order to comply with the requirements of deregulation and competition.  The Company’s rates are now subject toregulation and approval by the PUCT, not the Company’s Board of Directors.

 

F-27

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Under the new law, the PUCT will establish schedules and procedures forthe Company to comply with the requirements of competition.  Because the Southwest Power Pool (“SPP”) doesnot have adequate infrastructure for customer choice, House Bill 1642 providesthat the utilities in the SPP cannot participate in customer choice until 2007.  Since the SPP still does not have adequateinfrastructure for customer choice, it is expected that such date will beextended by the legislature.  Themajority of the Company’s service area is in the SPP, while approximately 25%is in ERCOT.  While the PUCT could orderthe Company to bring its ERCOT territory into customer choice sooner than thelaw provides for customer choice to be provided by utilities in the SPP, suchaction would only serve to harm the Company’s customers and the Company doesnot believe the PUC will take such action. The Company believes the PUCT will be reasonable in developingappropriate schedules and procedures for the Company to enter into customerchoice and that such action will not adversely affect the Company’s customers.

 

**21. RELATED PARTY ACTIVITY**

 

One of the compensation vehicles utilized by the Company was theAchievement Based Contract – Southwestern Public Service Company (“ABC-SPS”).  The ABC-SPS contract provided 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 werethe only remaining participants in the ABC-SPS contract, which expired inOctober 2003.  For the years ended December31, 2003 and 2002, compensation attributable to the contract was $126,000 and$156,000, respectively.

 

Two other compensation arrangements, the Achievement Based CompensationContract – Merger or Acquisition with Other Electric Utilities, and the AchievementBased Compensation Agreement – Corporate Asset Non-CFC Financing Arrangements,were also in place in prior years.  Thesecompensation arrangements were cancelled in March 2005, and no amounts had beenpaid or accrued for the years ended December 31, 2004, 2003 and 2002.

 

**22. OTHER SHAREHOLDER MATTERS**

 

The Cap Rock Energy Corporation Shareholders’ Trust (the “Trust”) wasestablished by 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 the twoTrustees of the Trust is to make distribution of stock to beneficial ownerswhen they have been located.  As ofDecember 31, 2004 and 2003, there were 325,223 and 340,738 shares of stock,respectively, held beneficially by the Trust.  Other powers are limited to those granted in the Trust document, theFunding Agreement and the Share Option Agreement.

 

The Trust provides that in the case of a tender offer or otherrepurchase offer by the Company for shares of the capital stock of the Company,the Trustees may, in their sole discretion and acting jointly in the bestinterest of the beneficiaries of the Trust, sell all of the shares held in theTrust to the Company at the highest cash price offered under the tender offeror other repurchase offer.  If the tenderoffer by the Company has a premium of 25% or more, the Trustees shall sell allof the shares at the highest cash price offered.  In addition, the Trustees shall not vote theshares in favor of a sale or pledge of assets of the Company, nor for anychange in the capital structure or powers of the Company or in connection witha merger or dissolution, unless previously approved by the Company’s Board ofDirectors.

 

On December 31, 2004, the Trust and the Company entered into a VotingAgreement whereby the shares that are currently held in the Trust will be votedby the Trustees but as directed by the Company for so long as the shares areheld in the Trust, or by the State in the event the shares escheat.  As consideration, the Company will pay a 10%premium of the value of the shares as of December 30, 2004, to any owner ofshares currently held in the Trust, at such time as the shares are issued tothe legal owner or his or her heirs.  AtDecember 31, 2004, a

 

F-28

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liability based on fair value of $129,000 was recorded, and is shown asa long term liability in Deferred credits on the consolidated balancesheet.  See Note 17.

 

**23. COMMITMENTS AND CONTINGENCIES**

 

The Company has various obligations to make future payments undercontractual obligations:

 
| ** **                   | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| ** **                   | ** ** | **(Thousands of dollars)** | ** ** |
| Operating  lease obligations |       | 485                        |       | 396      |       | 322      |       | 137      |       | 137      |       | 91             |       | 1,568     |       |
| Purchase  obligations        |       | 6,969                      |       | 2,099    |       | 2,099    |       | 402      |       | 402      |       | 2,802          |       | 14,773    |       |
| Other long  term liabilities |       | 1,543                      |       | 1,531    |       | 921      |       | 859      |       | 797      |       | 33,926         |       | 39,577    |       |

 

Operating leases relate primarily to equipment.  Purchase obligations include IT services andpower contracts.  All of the Company’spower 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.  The amountsincluded for each year are basic required transmission charges.

 

The Company has entered into an agreement with a third party to providecertain information technology related managed services including assessment ofthe current IT environment and future needs; product selection; implementationof financial and operational IT systems; hosting of the applications in aremote environment; user and application support, as well as desktopsupport.  Beginning March 2004, ongoingmaintenance and support costs is be based on the number of meters perrespective month and, based on the number of meters at December 31, 2004, 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.

 

The Company has a contract with the City of Farmersville, Texas, to actas an agent to provide power to its customers and assume all related billingand collection functions.  Terms providefor a two year written notification for termination by either party.  The Company is obligated to make payments tothe City of Farmersville on a revenue sharing type basis.  The 2005 and estimated 2006 annual paymentsare $621,000 and are reflected in the table under Other long term liabilities.

 

***Purchased Power and TransmissionServices. ***The Company purchases all of its electricpower pursuant to long-term wholesale electric power contracts withSouthwestern Public Service Company, Lower Colorado River Authority (“LCRA”)and Garland Power and Light (“Garland”). SPS, LCRA and Garland contracts expirein 2013, 2016 and 2005, respectively, and account for approximately 74%, 14%and 12%, respectively, of the Company’s electric power purchases for 2004. Thecontracts for power cover kWh usage, kW demand levels, transmission, schedulingand ancillary services along with energy and fuel costs. The Company’spurchased power costs fluctuate primarily with the price of the fuel and usage.Management believes that in the event the contracts are terminated, the Company’soperations will not be severely affected as new contracts can be secured atcompetitive rates with other electric power providers.  However, all costs associated with purchasedpower are passed through to the retail customer.

 

The Company’s west Texas divisions are supplied power through acontract with SPS. The SPS contract has no minimum kWh usage requirements, butdoes have minimum charges for kW demand and transmission services. The Companymust pay a minimum of 65% of the prior twelve months highest monthly kW demandusage multiplied by a fixed rate along with their pro-rata share of the fixedtransmission costs based on the Company’s prior twelve months usage as apercentage of all SPS usage. The aggregate cost of the contract with SPS for2004 and 2003 was $27,322,000 and $23,114,000, respectively.

 

F-29

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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.

 

The LCRA contract covers all power utilized by the central Texasdivision of the Company and permits the Company to purchase 100% of the powerneeded to supply the native load of the division. LCRA charges the Companyfixed factors for energy, kW demand and scheduling services applied to ourusage. LCRA’s transmission charges are fixed monthly charges regulated by theElectric Reliability Council of Texas (“ERCOT”). Fuel costs paid to LCRA arethe Company’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.

 

Garland provides all power supply requirements, including ancillary andscheduling services, 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.

 

Various members of ERCOT provide the northeast Texas division of theCompany with transmission services. The PUCT regulates the transmission ratesthat are charged by the ERCOT members. The Company pays a fixed monthly feebased on the estimated usage submitted prior to the beginning of each year.There is no contract with the individual ERCOT members. Taking power over theERCOT network requires the Company to pay fees regulated by the PUCT. Theannual charges to use the ERCOT transmission network cover the period fromJanuary 1 to December 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.

 

***Outsourced Functions. ***The Company utilizes an outside third party for its materialswarehousing function.  The terms of thecontract provide that the third party maintain an adequate level of inventoryin order that 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 the contractalso provide for termination at any time by either party with 90 days writtennotice.  Upon any final contracttermination by either party, the Company is required to purchase and pay forany inventory held by the third party at cost plus 10%.  The estimated inventory value plus 10% isapproximately $1,091,000 at December 31, 2004.

 

The Company has also outsourced its meter reading function.  The basic terms of the contract provide for afee per meter read, with the contract extended through 2008, unless eitherparty gives 150 days written notice at any time.

 

***PUCT Oversight and Decisions.*****Because of a change in the Public UtilityRegulatory Act (“PURA”), as of September 1, 2003, the Company’s rates becamesubject to regulation and approval by the PUCT, not the Company’s Board ofDirectors.   In accordance with thischange in the PURA, the Company filed its tariffs for electric service onSeptember 2, 2003.  The staff of the PUCTreviewed those tariffs and provided comments and proposed changes to bring thetariffs into compliance with PUCT rules and regulations.  Because the tariffs, when adopted, were notsubject to PUCT regulation, some of the provisions did not comply with PUCTrules and regulations since that was not a requirement when the tariffs wereadopted.  Now that the Company is subjectto PUCT regulation, the Company made proposed amendments to its tariff assuggested by the PUCT staff.  The PUCTstaff reviewed the proposed changes and recommended that the tariff beapproved.  Prior to the AdministrativeLaw Judge entering a ruling approving the tariff, with the proposed changes,several of the group of intervenors in the case were successful in obtaining alegislative request that the matter be referred to the State Office ofAdministrative Hearings (“SOAH”) for a hearing on the merits.  As a result, the matter was referred to SOAHand a hearing is currently scheduled for April, 2005.  The hearing will be limited to whether the

 

F-30

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tariffs filed by the Company are the actual tariffs that were properlyapproved by the Company’s Board of Directors, which was the Company’s previousregulatory authority.  The Companybelieves the issue is moot because any current tariff will be superseded by thetariff that is ultimately approved by the PUCT in the rate case.

 

In October 2004, the PUCTinitiated an inquiry to determine the reasonableness of the Company’s rates andordered the Company to submit a rate filing package.  The Company prepared and filed a rate filingpackage that contained a request for a rate increase for some customer classes.  The Company initially requested a $6,333,000overall annual after tax increase but due to adjustments made while preparingfor the hearing on the merits in the case, that amount was adjusted downward to$5,021,000.  Hearings were held beforethe State Office of Administrative Hearings from October 5, 2004, throughOctober 14, 2004.  During such hearings,the Company presented testimony and evidence in support of its requested rateincrease.  Numerous intervening partiesand the PUCT staff presented evidence and testimony in opposition to the rateincrease and in support of a rate decrease. The parties filed briefs in support of their positions and the Companyhas agreed to extend the effective date for the requested rate increase untilJune 17, 2005.  A hearing was held inDecember 2004, to determine the amount of rate case costs that the PUCT willallow the Company to recover from its customers, as well as the period ofrecovery.  The Company believes all ofits rate case costs are reasonable and necessary and should berecoverable.  Any amount not allowed forrecovery will be expensed immediately. As of December 31, 2004, $3,593,000 of third party costs had beenincurred in connection with the rate case, and are shown on the balance sheetas a regulatory asset because they were deferred pending approval of recoveryby the PUCT.

 

On March 17, 2005, the Administrative Law Judges (“ALJ’s”)issued a Proposal for Decision (“PFD”). The PFD recommended a 7.49% rate decrease for Cap Rock.  This amounts to an annual revenue decrease ofapproximately five million dollars. Several intervenors had sought rate decreases which were much largerthan the recommendation of the ALJ’s. The recommendation by the ALJ’s will be considered by the PUCT at anopen hearing.  A final ruling, which canbe appealed by Cap Rock or any of the intervenors, is expected by June 2005.

 

The Company feels that its rates and its requestedsmall rate increase are justified and that its evidence support that.  The Company will request that the PUCT rejectthe recommendation of the Administrative Law Judges and grant its requestedrate increase.  The Company has receivedrecommendations from Administrative Law Judges in the past which were not inits favor, only to prevail when the issues were considered by the PUCT.  The Company believes its rates are reasonableand that the requested rate increase is appropriate based upon its cost ofservice and reasonable return on its rate base. However, the Company cannot determine what action the PUCT will takewith respect to the PFD.

 

If the Company’s request for a rate increase is approved by the PUCT,the Company may suffer a decline in its customer base.  Because the outcome of the rate request orrate order is unknown until the PUCT makes a final ruling, the Company isunable to predict the effect of such ruling.

 

The Company determined during the rate case thatpower costs had been overcollected under the Company’s retail tariffs throughthe power cost recovery process.  Thiswas disclosed to the PUCT at that time. These monies are currently being returned to customers through powercost recovery refunds.  Thisovercollection is partially offset by a credit applied to power cost recoverydue to the change in accounting principle to record revenues by the accrualmethod, rather than the as-billed method. Legal issues regarding this over recovery and the method of refunding itare being discussed with the PUCT staff and the ultimate outcome is currentlyunknown.  The Company has recorded aliability for these costs.  However, thisis subject to PUCT approval.

 

The Company received two Notices of Violation (“NOV”)from the PUCT in September 2004.  TheseNOV’s, which contain recommendations of the PUCT staff, are the result ofchanges in the Public Utility Regulatory Act (“PURA”) passed in 2003, whichchanged the way the Company was regulated. Prior to September 1, 2003, the Company’s rates were lawfully regulatedby its Board of Directors, the same way all electric cooperatives in the stateare regulated.  During the 2003legislative session, a small group of customers, who were opposed to the

 

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Company’s conversion from an electric cooperativeto a shareholder owned corporation, were successful in getting the law changedso that the Company would be regulated by the PUCT instead of its Board ofDirectors.  The changes, which tookeffect September 1, 2003, applied only to the Company and did not affect theway any other utility in the state is regulated.

 

The NOV’s cite the Company for charging late feesto residential customers who did not pay their bills on time, and for charginga regulatory surcharge to customers to recover costs incurred in a prior PUCTproceeding.  Both of these charges weremade in accordance with the Company’s tariff which had been adopted by itsBoard of Directors in accordance with Texas law at the time.  Once the Company came under the regulatoryauthority of the PUCT on September 1, 2003, it filed those tariffs with the PUCTand the PUCT staff reviewed the tariffs and made recommendations to bring thetariffs into compliance with the rules and regulations of the PUCT and thePURA.  The Company amended its tariffs tomake all of their suggested changes and the proposed tariff, with theamendments, was filed and is currently awaiting approval by the PUCT.  The charges for which the Company was citedrelate to charges that were made under the Company’s legally adopted andapproved tariff.  The Company has filed aproposed tariff which complies with the PUCT rules and regulations, but due toactions of a small group of customers, this tariff has not yet been approved bythe PUCT.

 

The NOV’s also recommend that the Company pay fines and customerrefunds in excess of $1.3 million.  Theseare the same claims that a small group of intervenors have been making in theCompany’s PUCT tariff proceedings.  Oncethe PUCT ruled that these allegations should not be considered with the Company’stariff filing, they were made in these enforcement actions.  The Company filed answers requesting asettlement conference with the PUCT staff and believed that the matters wouldbe disposed of through that conference. However, a resolution was not reached and in early November the Companyrequested a hearing with the State Office of Administrative Hearings.  TheCompany feels strongly about its legal position on these issues and believes itwill ultimately prevail.

 

ThePUCT has not yet established the procedures and time lines for the Company tocomply with the other provisions of the PURA regarding investor ownedutilities, including offering customer choice for customer powerrequirements.  The Company anticipatesthat the PUCT will take relevant factors into consideration in establishingsuch procedures and time lines that are appropriate and such actions will notadversely affect the Company’s customers.

 

***Lamar. ***Discovery is ongoing in the litigation involvingthe Company and Lamar Electric Cooperative Association, Inc. (“Lamar”) whicharose out of Lamar’s termination of the Combination Agreement between Lamar andthe Company in October 2002 and the Management Services Agreement in November2002.  Lamar filed suit against theCompany in the 62nd District Court in Lamar County, Texas, seeking adeclaratory judgment that it had a right to terminate both agreements withoutregard to payment of any kind to the Company. The Company believes that Lamar’s stated reason for termination of theCombination Agreement does not fall within the specific allowable exceptionsset forth in the agreement, and therefore the Company is seeking reimbursementof all costs and expenses incurred with regard to the attempted combinationwhich amount to at least $1.4 million as well as a cancellation fee of $300,000for liquidated damages as set out in the terms of the Management ServicesAgreement.

 

In October 2004, the Company filed counterclaimsagainst Lamar’s Board of Directors and two individual directors.  The Company also joined several third partiesalleging fraud, civil conspiracy and tortuous interference with businessrelations.  Lamar has also amended itssuit against the Company, adding claims for fraud and misrepresentation.  It is likely there will be additionaldiscovery on the new claims, and the matter will most likely not go to trialprior to the fourth quarter of 2005.

 

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

 

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**24.  INCOME TAXES (RESTATED)**

 

The Company 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.

 

The Company identified a technical tax issue related to the income taxtreatment, for financial reporting purposes, regarding the tax exempt status ofone of the Company’s subsidiaries.  SeeNote 2 concerning restatement of previously issued financial statements.

 

The following is a reconciliation of expected income tax expense toactual expense as well as the reconciliation of the statutory tax rate to theeffective rate for the years ended December 31, 2004 and 2003 (in thousands):

 
| ** **                                | ** ** | **2004**       | ** ** | **2003**       | ** ** |
|-------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                | ** ** | **Dollars**    | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| ** **                                | ** ** | **(Restated)** | ** ** | ** **     | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
|                                      |       |           |       |           |       |   |   |   |   |
| Income tax  expense at the statutory rate |       | $              | 1,120      |           | 34.0       | % | $ | 4,534 |   | 34.0 | % |
| State tax  expense                        |       | 190            |       | 5.8            |       | 258 |   | 1.9 |   |
| Expired  capital loss                     |       | 2,540          |       | 77.1           |       | — |   | — |   |
| Change in  valuation allowance            |       | (5,240         | )          | (159.1         | )          | (2,707 | ) | (20.3 | ) |
| Other                                     |       | 1,158          |       | 35.1           |       | 52 |   | 0.4 |   |
|                                      |       | $              | (232       | )              | (7.1       | )% | $ | 2,137 |   | 16.0 | % |

 

The tax effects ofsignificant temporary differences and carryforwards at December 31, 2004 and2003, are as follows (in thousands):

 
| ** **                              | ** ** | ** ** | ** ** | **2004**       | ** ** | **2003**       | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
|                                    |       |       |       |           |       |           |       |       |       |
| Net deferred  tax assets (liabilities): |       |       |       |           |       |           |       |       |       |
|                                    |       |       |       |           |       |           |       |       |       |
| Accrued  expenses                       |       |       |       | $              | 1,260      |           | $          | 1,007      |       |   |   |
| Allowance  for doubtful accounts        |       |       |       | 38             |       | 28             |       |       |       |
| Net  operating loss carryforwards       |       |       |       | 4,154          |       | 4,223          |       |       |       |
| Stock  compensation                     |       |       |       | 1,320          |       | 751            |       |       |       |
| Capital loss  carryforwards             |       |       |       | —         |       | 2,765          |       |       |       |
| Total deferred tax assets               |       |       |       | 6,772          |       | 8,774          |       |       |       |
|                                    |       |       |       |           |       |           |       |       |       |
| Property and  equipment                 |       |       |       | (6,799         | )          | (3,362         | )          |       |       |
| Other                                   |       |       |       | (1,248         | )          | (172           | )          |       |       |
| Total deferred tax liabilities          |       |       |       | (8,047         | )          | (3,534         | )          |       |       |
|                                    |       |       |       |           |       |           |       |       |       |
| Valuation  allowance                    |       |       |       | —         |       | (5,240         | )          |       |       |
| Net deferred tax asset (liability)      |       |       |       | $              | (1,275     | )              | $          | —     |       |   |   |

 

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As of December 31, 2004, the Company has net operating losscarryforwards of approximately $12,218,000. The net operating loss carryforwards are scheduled to expire in 2021through 2024.

 

In early 2004, the IRS notified the Company that it intended to examinethe federal income tax return of its Predecessor for the year 2001.  The Company and the IRS are in the finalstages of that process, and Management believes there will be no materialimpact on the Company’s financial position or results of operations.

 

**25. SEGMENT INFORMATION**

 

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

 

Business segment information as of and for the years ended December 31,2004, 2003 and 2002, is as follows (in thousands):

 
| ** **                     | ** ** | **TOTAL** | ** ** |
|--------------------------------|------------|-----------|------------|
| Operating  revenues            |       |      |       |
| December 31, 2004              |       | $         | 82,624     |   |
| December 31, 2003              |       | 82,844    |       |
| December 31, 2002              |       | 74,637    |       |
| Net income                     |       |      |       |
| December 31, 2004              |       | 3,525     |       |
| December 31, 2003              |       | 11,198    |       |
| December 31, 2002              |       | 8,776     |       |
| Identifiable  assets           |       |      |       |
| December 31, 2004 (Restated)   |       | 199,687   |       |
| December 31, 2003              |       | 202,989   |       |
| December 31, 2002              |       | 211,294   |       |
| Capital  expenditures          |       |      |       |
| December 31, 2004              |       | 4,583     |       |
| December 31, 2003              |       | 5,209     |       |
| December 31, 2002              |       | 1,517     |       |
| Depreciation  and amortization |       |      |       |
| December 31, 2004              |       | 7,416     |       |
| December 31, 2003              |       | 6,719     |       |
| December 31, 2002              |       | 5,834     |       |
| Interest  expense, net         |       |      |       |
| December 31, 2004              |       | 7,983     |       |
| December 31, 2003              |       | 8,047     |       |
| December 31, 2002              |       | 7,403     |       |
|                                |            |           |            |  |

 

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**26. QUARTERLY FINANCIAL DATA (UNAUDITED)**

 

The following table summarizes results for each of the four quarters inthe years ended December 31, 2004 and 2003 (in thousands, except per sharedata):

 
| ** **                            | ** ** | **As  Reported**                            | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                            | ** ** | **(In thousands except per share amounts)** | ** ** |
|                                  |       |                                        |       |            |       |             |       |
| **Quarter  ended March 31, 2004**     |       |                                        |       |            |       |             |       |
| Total revenues                        |       | $                                           | 20,288     |            | $          | —           |       | $ | 20,288 |   |
| Operating income                      |       | 4,241                                       |       | —          |       | 4,241            |       |
| Net income before income taxes        |       | 2,249                                       |       | —          |       | 2,249            |       |
| Income tax expense                    |       | 187                                         |       | 287             |       | 474              |       |
| Basic earnings per share              |       | 1.32                                        |       | (0.19           | )          | 1.13             |       |
| Diluted earnings per share            |       | 1.27                                        |       | (0.18           | )          | 1.09             |       |
|                                  |       |                                        |       |            |       |             |       |
| **Quarter  ended June 30, 2004**      |       |                                        |       |            |       |             |       |
| Total revenues                        |       | 22,831                                      |       | —          |       | 22,831           |       |
| Operating income                      |       | 5,966                                       |       | —          |       | 5,966            |       |
| Net income before income taxes        |       | 4,026                                       |       | —          |       | 4,026            |       |
| Income tax expense                    |       | 997                                         |       | 14              |       | 1,011            |       |
| Basic earnings per share              |       | 1.94                                        |       | (0.01           | )          | 1.93             |       |
| Diluted earnings per share            |       | 1.87                                        |       | (0.01           | )          | 1.86             |       |
|                                  |       |                                        |       |            |       |             |       |
| **Quarter  ended September 30, 2004** |       |                                        |       |            |       |             |       |
| Total revenues                        |       | 22,351                                      |       | —          |       | 22,351           |       |
| Operating income                      |       | 1,614                                       |       | —          |       | 1,614            |       |
| Net income before income taxes        |       | 190                                         |       | —          |       | 190              |       |
| Income tax expense (benefit)          |       | (658                                        | )          | 826             |       | 168              |       |
| Basic earnings per share              |       | 0.56                                        |       | (0.55           | )          | 0.01             |       |
| Diluted earnings per share            |       | 0.54                                        |       | (0.53           | )          | 0.01             |       |
|                                  |       |                                        |       |            |       |             |       |
| **Quarter  ended December 31, 2004**  |       |                                        |       |            |       |             |       |
| Total revenues                        |       | 17,154                                      |       | —          |       | 17,154           |       |
| Operating income (loss)               |       | (1,602                                      | )          | —          |       | (1,602           | )          |
| Net income (loss) before income taxes |       | (3,172                                      | )          | —          |       | (3,172           | )          |
| Income tax expense (benefit)          |       | (2,666                                      | )          | 781             |       | (1,885           | )          |
| Basic earnings (loss) per share       |       | (0.90                                       | )          | 0.06            |       | (0.84            | )          |
| Diluted earnings (loss) per share     |       | (0.87                                       | )          | 0.03            |       | (0.84            | )          |
|                                       |            |                                             |            |                 |            |                  |            |  |  |  |

 
| ** **                      | ** ** | **QUARTER ENDED** | ** ** |
|---------------------------------|------------|-------------------|------------|
| ** **                      | ** ** | **MARCH 31,**     | ** ** | **JUNE 30,** | ** ** | **SEPTEMBER 30,** | ** ** | **DECEMBER 31,** | ** ** |
| **Period  ended December 2003** | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenues                  |       | $                 | 22,344     |   | $ | 19,243 |   | $ | 23,343 |   | $ | 17,914 |   |
| Operating income                |       | 5,457             |       | 4,897 |   | 6,936 |   | 3,679 |   |
| Net income before income taxes  |       | 3,760             |       | 3,283 |   | 4,718 |   | 1,574 |   |
| Income tax expense              |       | 699               |       | 678 |   | 80 |   | 680 |   |
| Basic earnings per share        |       | 2.35              |       | 2.00 |   | 2.96 |   | .57 |   |
| Diluted earnings per share      |       | 2.25              |       | 1.92 |   | 2.86 |   | .55 |   |
|                                 |            |                   |            |  |  |  |  |  |  |  |  |  |  |

 

See Note 2 for a discussion ofthe adjustments related to the restatement.

 

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