**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,D. C. 20549**

 

**FORM 10-K**

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

 

**FOR THEFISCAL YEAR ENDED DECEMBER 31, 2002**

 

**COMMISSIONFILE NUMBER0-32667**

 

**CAP ROCK ENERGYCORPORATION**

 

| **Texas**                                                                 |   | **75-2794300**                        |
|---------------------------------------------------------------------------|--------|---------------------------------------|
| (State of Incorporation)                                                  |   | (I.R.S. Employer  Identification No.) |
|                                                                      |   |                                  |
| **500 West  Wall Street, Suite 400  Midland, Texas**                      |   | **79701**                             |
| (Address of principal  executive office)                                  |   | (Zip Code)                            |
|                                                                      |   |                                  |
| Registrant’s telephone  number, including area code **915-683-5422** |

 

Securities registered pursuant to Section12(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 registered pursuant to Section 12(b) of the Act:                              **NONE**

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

 

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

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form 10-K.

 

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

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Act).

 

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

 

**THE AGGREGATE MARKET VALUE OF THE COMMONSTOCK HELD BY NON-AFFILIATES OF THE REGISTRANT AS OF JUNE 28, 2002, WASAPPROXIMATELY $15,042,200 BASED ON THE CLOSING PRICE OF $11.55 FOR THE COMMONSTOCK ON THE AMERICAN STOCK EXCHANGE AS REPORTED BY THE WALL STREET JOURNAL.**

 

**THE NUMBER OF SHARES OF COMMON STOCKOUTSTANDING ON MARCH 25, 2003, WAS 1,302,355.DOCUMENTS INCORPORATED BY REFERENCE**

**None**

 

 

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**PART I**

 

**ITEM 1. BUSINESS**

 

**The Company**

 

Cap Rock Energy Corporation, its subsidiariesand affiliates (the “Company”) own and operate an electric distribution andtransmission business in various non-contiguous areas in the State of Texas.The Company primarily provides electric distribution service to over 35,000meters in 28 counties in Texas. This includes 23,000 meters in 17 counties inthe Midland-Odessa area of West Texas (the “West Texas Division”), 6,100 metersin the Central Texas area around Brady, Texas, and over 4,200 meters inNortheast Texas in Hunt, Collin and Fannin Counties. The Company also providesmanagement services to the Farmersville Municipal Electric System whichservices nearly 1,700 meters in Farmersville, Texas.  The Company’s predecessor in interest, Cap Rock ElectricCooperative, Inc. (the “Cooperative”), was incorporated as an electriccooperative in the State of Texas in 1939.

 

The Company was formed in December 1998 inaccordance with a conversion plan adopted by the members of the Company’spredecessor, the Cooperative, which provided a method for changing thecorporate structure from a member owned cooperative to a shareholder ownedcorporation. The conversion plan provided for the transfer of all of theCooperative’s assets and liabilities to the Company. It also provided for thepayment of the equity accounts and membership interests, if any, of members ofthe Cooperative through cash, credit on their electric bill or stock in theCompany, at the member’s option. The Company operated as a wholly ownedsubsidiary of the Cooperative until the conversion plan was implemented. Otherthan the Certificate of Convenience and Necessity (“CCN”), all of theCooperative’s assets were transferred to the Company in accordance with theconversion plan and the Company assumed all of the Cooperative’s liabilities inearly 2002. On February 8, 2002, the Company issued stock to all former membersof the Cooperative who chose stock as the method of payment for their equityand membership interest, if any, in the Cooperative. All former members whochose the cash payment option were paid in late 2001.  The former members who chose credits on their electric bill arestill receiving those credits, with such credits expected to be fully appliedby the end of 2003.

 

An application has been filed with the PublicUtility Commission of Texas (“PUCT”) to transfer the Cooperative’s CCN to theCompany.  The CCN allows its holder toserve customers in specified geographical territories.  When the CCN is transferred, the Cooperativewill be dissolved and the Company will provide services directly to its retailcustomers.   While the Company’scorporate structure changed from a member owned electric cooperative to ashareholder owned utility in 2002, it is still currently subject to regulationby the PUCT in the category of a cooperative, although that status has beenchallenged in proceedings currently pending before the PUCT, and is the subjectof a proposed bill in the Texas legislature. See “Business - State and FederalRegulation.”

 

The Company purchases power for resale to itsretail customers from wholesale suppliers and distributes that power to itscustomers over its transmission lines covering over 320 miles and then over11,000 miles of distribution lines.  TheCompany’s transmission systems interconnect with the systems of power suppliersand other utilities, to permit bulk power transactions with other electricitysuppliers.  One of the Company’swholly-owned subsidiaries, NewCorp Resources Electric Cooperative, Inc.(“NewCorp”), owns and operates 305 miles of transmission line which are in theSouthwest Power Pool (“SPP”).  Thistransmission system is subject to regulation by the Federal Energy RegulatoryCommission (“FERC”).  NewCorp providestransmission services to the Company pursuant to a FERC regulated tariff.  The Company also owns 18 miles oftransmission line located in McCulloch County, Texas, and which are in theElectric Reliability Council of Texas (“ERCOT”).  This small transmission line is currently leased to a powerprovider, Lower Colorado River Authority (“LCRA”).   The Company owns approximately 9,800 miles of overheaddistribution lines and approximately 1,900 miles of underground distributionlines.  The Company believes it has allthe franchises and licenses necessary to distribute electricity within theterritories where its distribution systems are located and from whichsubstantially all of its gross operating revenue is derived.

 

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The Company’s primary focus is ondistribution of electricity to its customers. The Company has not and does not plan to engage in the generation ofelectricity.  In 2002, the Companypurchased all electric power pursuant to wholesale electric power contractswith Southwestern Public Service Company (“SPS”), Dynegy Power Marketing, Inc.(“Dynegy”), Lower Colorado River Authority and Garland Power and Light(“Garland”), which accounted for approximately 71.4%, 7.6%, 12.9% and 8.1%,respectively, of the electric power purchases of the Company. Generally, thewholesale electric power supply contracts are based on fixed charges for kWhusage, transportation and auxiliary services and a variable charge for fuelbased on kWh usage. The Company’s purchased power costs fluctuate primarilywith the price of natural gas. The contracts with SPS, LCRA and Garland expirein 2013, 2016 and 2004, respectively. The Company negotiated a new contract with Garland in 2002 whichreplaced the Dynegy contract and a previous contract with Texas-New MexicoPower Company.  We cannot predict whateffect, if any, renegotiation of future expiring contracts may have on theCompany’s financial condition and results of operations. However, all costsassociated with purchased power are passed through to the retail customer.

 

**Non-Electric Utility Business**

 

The Company has investments in the realestate business, the oil and gas business and the petroleum distributionbusiness, none of which separately or collectively account for 10% or more ofthe Company’s revenues. See Notes 9 and 11 to consolidated financialstatements.

 

In the past, the Company invested in the oiland gas exploration and production business. The Company no longer makesinvestments in oil and gas production and exploration. However, the Company hascontinued to invest in hydrocarbons through its ownership of a company formedto acquire oil and gas mineral and royalty interests. In December 2000, theCompany merged its mineral and royalty company with a company with similargoals. The merged company, Map Resources, Inc. (“MAP”), owns oil and gasminerals and royalties and some non-operated working interests. MAP’s primaryfocus in the future is the acquisition and continuing development of mineraland royalty interests. The Company owns approximately 42% of the common stockof MAP, which does not represent a significant portion of the Company’sbusiness.

 

The Company has provided a loan to UnitedFuel and Energy Company (“United Fuel”) which is engaged in the petroleumdistribution business. At loan closing, the Company acquired a 10% interest inUnited Fuel with a right to acquire an additional 10% interest under certaincircumstances. In January 2001, the Company acquired a net 5% additionalinterest in United Fuel from certain selling shareholders of United Fuel,giving the Company a 15% interest in the petroleum distribution company.  Under certain conditions, the Company has aright to acquire up to 25% in total of United Fuel. See Note 9 to theconsolidated financial statements included herein.

 

The Company’s real estate investments consistprimarily of building and land related to the electric business. The Company isalso an investor in certain limited partnerships which own and operateinterests in real properties. See “Item 2. Properties” for additionalinformation.

 

For additional information with respect tothe Company’s business segments, see Note 28 to the consolidated financialstatements.

 

**Seasonal Nature of Business**

 

The Company’s operating revenues come fromelectric or electric related sales. Annual sales to the Company’s commercialand industrial,  residential andirrigation customers have historically accounted for approximately 50%, 40%,and 10%,  respectively, of totalelectric sales.

 

Commercial and industrial revenues, derivedprimarily from electric powered oilfield equipment, are generally not subjectto seasonal fluctuation, or normal oil price fluctuations. This is because manyproducers have pre-committed their output. Electric power requirements can,however, be affected by a dramatic change in the price of oil, which affectsthe overall market for oil.

 

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Residential sales vary withtemperature fluctuations, primarily during the summer months, as the Company’sresidential customers use more electric power for cooling during the hot summermonths. Historically, approximately 33% of the Company’s annual residentialsales occur during the three month period ending September 30.

 

Irrigation revenues, derivedprimarily from cotton farmers with electric powered irrigation equipment, aresubject to temperature and rainfall fluctuations during the cotton planting andgrowing seasons. Historically, approximately 70% of the Company’s annualirrigation sales occur during the six month period ending September 30.

 

**Single Customer Reliance**

 

During the year ended December31, 2002, nine months ended December 31, 2001, and the year ended March 31,2001, the Company had no single customer that accounted for more than 10% ofits electric revenues.

 

**Employees**

 

As of December 31, 2002, theCompany had 116 full-time and two part-time employees, exclusive of temporaryemployees and contractors. None of the employees are members of any laborunions as of December 31, 2002.

 

**State and Federal Regulation**

 

***State Regulation***

 

In 1999, the Texas legislaturepassed, and the Governor signed, legislation that provided for therestructuring of the electric utility industry in the State of Texas. Thelegislature found the production and sale of electricity is not a monopolywarranting regulation of rates, operations and services.  Competitive electric markets require that,except for transmission and distribution services and for recovery of strandedcosts, electric services and the associated prices should be determined bycustomer choice and the normal forces of competition.

 

The purpose of customer choiceis to create a competitive retail market by allowing each retail customer tochoose their provider of electricity and by encouraging full and faircompetition to recover excess costs over market of those assets and purchasedpower contracts. Municipally owned utilities and electric cooperatives aretreated differently from other utilities under the state statute providing forcustomer choice. The statute has separate, specific provisions applicable toinvestor owned electric utilities, which were required to have customer choicein their service areas beginning January 1, 2002, and municipally ownedutilities and electric cooperatives, which are able to choose whether or not toopt into retail competition. These provisions individually govern thetransition to and establishment of a fully competitive electric power industryfor investor owned utilities, electric cooperatives and municipally ownedutilities.  Customer choice is only forthe provision of electricity and not for distribution or transmission services.

 

On or before September 1, 2000,each investor owned electric utility was required to separate its regulatedutility activities from its customer energy services business activities. ByJanuary 1, 2002, each investor owned electric utility operating in the State ofTexas was required to separate its business activities into a power generationcompany, a retail electric provider and/or a transmission and distributionutility. The Company is a transmission and distribution utility. Each investorowned electric utility was also required to submit a plan segregating businesses,which was subject to review by the PUCT. After January 1, 2002, a transmissionand distribution company may not sell electricity or otherwise participate inthe market for electricity except for the purpose of buying electricity toserve its own customers.

 

Commencing January 1, 2002,through January 1, 2007, any affiliated retail electric provider was requiredto make available to residential and small commercial customers of itsaffiliated transmission and distribution utility, rates, that, on a bundledbasis, are six percent less than the affiliated electric utility’scorresponding average residential and small commercial rates that were ineffect on January 1, 1999, which is the so-called “price to beat.”  Once customer choice was introduced, these utilitiescould not change rates for residential and small commercial customers that weredifferent from the “price to beat” until the earlier of 36 months or until 40%or more of the electric power consumed within the affiliated transmission anddistribution utility’s certificated service area before the onset of customerchoice is committed to be served by nonaffiliated retail electric providers. Asimilar restriction was set for rate changes for small commercial customers.

 

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The effect of the statute wasto freeze all investor owned electric utility rates that were in effect onSeptember 1, 1999, until January 1, 2002, and, upon completion of the phase inof customer choice, to lower rates to residential customers and smallcommercial customers by another six percent. If the “price to beat” jeopardizedthe financial integrity of the retail electric provider, the PUCT was requiredto set a price that would maintain the financial integrity of the retail electricprovider, but in no event more than the level of rates, on a bundled basis,charged by the affiliated electric utility on September 1, 1999, adjusted forfuel. For the year ended December 31, 2002, approximately 66% of the Company’srevenues were derived from residential customers and small commercial customerswith the remaining 34% attributable to irrigation and large commercialcustomers.

 

Electric cooperatives were notrequired to participate in deregulated markets. Under the separate provision inthe statute pertaining to electric cooperatives, the board of directors of acooperative has the discretion to decide if and when the electric cooperativewill provide customer choice. Electric cooperatives were not required tofunctionally unbundle their operating and business activities as investor ownedutilities were required to do. If an electric cooperative elects to participatein customer choice, all retail customers within the certificated service areaof the cooperative shall have the right of customer choice. An electriccooperative that does not elect to participate in the deregulated market,however, is prohibited from selling electric energy at unregulated pricesdirectly to retail customers outside its certificated retail service area.

 

The definition of electriccooperative under the state statute includes a provision that allows theCompany to be treated like an electric cooperative, and therefore be able toelect whether to participate in retail competition, and, if so, whether tounbundle its operations. Specifically, the definition of “electric cooperative”includes “a successor to an electric cooperative created before June 1, 1999,in accordance with a conversion plan approved by a vote of the members of theelectric cooperative, regardless of whether the successor later purchases,acquires, merges with or consolidates with, other electric cooperatives.”Management believes that the Company qualifies for treatment as an electriccooperative under this provision and that it is the only investor owned utilitythat does qualify for such treatment. A small group of interveners arecurrently challenging the Company’s right to be treated as a cooperative underthe Public Utility Regulatory Act. This challenge is being made before the PUCTproceeding in which the Company and the Cooperative have requested that theCooperative’s Certificate of Convenience and Necessity be transferred to theCompany. See “Legal Proceedings.”  Ifthe Company prevails, even as a shareholder owned utility, the Company has andwill continue to have all rights and privileges associated with being anelectric cooperative because it falls within the definition of electriccooperative established by the statute. Consequently, the Company will havemore options available to it than cooperatives and other shareholder ownedutilities, because it allows the Company to continue to compete in the marketwhile allowing it the time it needs to become more prepared for entering thederegulated market.

 

Senate Bill 1280 (“SB 1280”) isproposed legislation in the Texas Legislature which, if passed, would amend thePublic Utility Regulatory Act, to treat a successor to an electric cooperativeas an investor owned utility.  SB 1280also provides for establishment by the PUCT of schedules and procedures inorder to comply with the requirements of deregulation for those successorswhich were not previously subject to regulation as an investor owned utilityprior to September 1, 2003.  Althoughthe bill has passed in committee, it must pass in both the Texas Senate andTexas House of Representatives before it becomes law.

 

Currently the Cooperative’sBoard of Directors, not the PUCT, approves all rates and tariffs that theCooperative charges its members. The Company’s Board of Directors has approvedthe rates that the Company charges its customers.

 

If an electric utilitypurchases, acquires, merges, or consolidates with or acquires 50 percent ormore of the stock of an electric utility or electric cooperative, the successorutility may be subject to regulation by the PUCT. Specifically, the PUCT wouldregulate the successor electric utility or electric cooperative in the samemanner that they would regulate the entity that was subject to the stricterregulation before the purchase, acquisition, merger or consolidation.Therefore, if the Company is acquired by another entity or merges with anotherentity under circumstances where the Company is not the survivor, the acquiringentity or the surviving entity, would not be allowed to retain the treatment asan electric cooperative.

 

Management believes that theCompany’s customers should have the ability to choose and the Company intendsto eventually participate in retail competition. The Company is concerned,however, as to the implications of the 

 

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uncertainties that have arisen with respectto deregulation in the states where deregulation has occurred or is occurring,particularly those in the West and Southwest. In addition, there is still some uncertainty in Texas regarding whetherthe legislation that has been enacted will be modified or remain in its currentform. The Company therefore believes that it is in the best interest of itscustomers to delay participation and defer incurring expenditures for upgradedsystems and additional personnel that would be necessary to participate inretail competition until there is more certainty. The Company’s Board ofDirectors has elected not to opt in for competition at the present time.

 

The effect on the Company ofderegulation in states other than Texas cannot be predicted because the Companyonly operates in Texas at the present time. However, if the Companysubsequently acquires electric distribution businesses outside of Texas, theeffect of deregulation in the state where the business is located could have amaterial, and possibly adverse, impact on the Company.

 

***Federal Regulation***

 

Federal legislation, such asthe Public Utility Regulatory Policy Act of 1978 and, more recently, theNational Energy Policy Act of 1992 and Texas legislation, such as the PublicUtility Regulatory Act of 1995, as amended, have significantly alteredcompetition in the electric utility industry. Among other things, the PublicUtility Regulatory Policy Act and the National Energy Policy Act encouragewholesale competition among electric utility and non-utility power producers.The National Energy Policy Act addresses a wide range of energy issues and isintended to increase competition in electric generation and broaden access toelectric transmission systems. At the state level, the Public UtilityRegulatory Act encourages greater wholesale competition, flexible retailpricing and requires the PUCT to report to the Texas legislature on competitionin electric markets.  The Company doesnot engage in the power generation business.

 

The National Energy Policy Actempowers the Federal Energy Regulatory Commission to require utilities toprovide transmission facilities for the delivery of wholesale power from otherpower producers to qualified resellers, such as municipalities, cooperativesand other utilities. The Company’s transmission facilities in its West Texasdivision, which are in the Southwest Power Pool, are subject to regulation bythe Federal Energy Regulatory Commission, and the Company’s transmissionfacilities in its McCulloch division, which are part of the ElectricReliability Council of Texas, Inc., are subject to regulation by the PUCT.During 2002, the Company applied for, and FERC has approved, the unbundling of transmissionrates to allow the full recovery of transmission costs of its West Texastransmission system. The unbundled tariff equals the tariff in the Company’sOpen Access Transmission Tariff.

 

**Competition and Restructuring**

 

The Company faces strong competitionin providing electric distribution services. Many of the Company’s competitors,like TXU Energy and its affiliate, Oncor, are much larger than the Company andhave financial resources that are much greater than the Company’s.  Oncor, which is the largest electric utilityin the State of Texas in terms of revenues and size of operating areas, iscertified to operate in many of the areas in West Texas where the Companycurrently operates and the Company competes with it on the basis of price andservice. In many cases the Company’s prices are higher than those of Oncor, butthe Company believes that it has retained many of its customers despite itsprices because of the quality of the services it provides.

 

Legislation passed in Texas in1999, which became effective January 2002, will significantly modify theindustry and potentially introduce more competition into the Texas retailmarket. The Company’s customers may be able to purchase electricity from otherproviders at prices that are less than the Company may be able to provide. Thelevel of competition is affected by several variables, including price, thecost of energy, alternative energy sources, new technologies and governmentalregulations. The Company, however would remain as the distributor of suchelectricity.  See “Business-State AndFederal Regulation.”

 

**Power Requirements**

 

Currently, the Companypurchases electric power through wholesale contracts with SPS, LCRA andGarland.  In 2002, SPS, LCRA and Garlandsupplied approximately 71.4%, 12.9%, and 8.1%, respectively, of the Company’selectric power purchases. The Company also had a wholesale power contract withDynegy which expired in 2002.  Dynegysupplied approximately 7.6% of the Company’s electric power purchases for2002.  The Company negotiated and signeda 

 

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new contract with Garland which replaced theDynegy contract and a previous contract with Texas-New Mexico PowerCompany.  The contracts with SPS, LCRAand Garland will expire in 2013, 2016 and 2004, respectively.  These contracts generally provide forpricing terms based upon the price of fuel and usage levels.  We cannot predict what effect, if any, renegotiationof other expiring contracts may have on the Company’s financial condition andresults of operations. However, all costs of power under the contracts arepassed through to the retail customer.

 

**Environmental Matters**

 

The Company is subject toregulations with respect to certain environmental matters by federal and stateauthorities. The Company is unaware of any present or potential environmentalproblems and believes it is in compliance with all environmentalregulations.  Environmental regulationscan change rapidly and are difficult to predict. Substantial expenditures maybe required to comply with these regulations. The Company analyzes thepotential costs arising from environmental matters on an ongoing basis, andmanagement believes it has adequate provision in its financial statements tomeet such obligations.

 

**Construction and Capital Requirements**

 

The Company has no majorconstruction projects planned at the present time. Utility constructionexpenditures for 2003 will consist primarily of costs to maintain the Company’stransmission and distribution systems and to upgrade the information technologysystems. Total gross property additions, including construction work inprogress, for the year ended December 31, 2002, nine months ended December 31,2002, and year ended March 31, 2001, were $1,517,000, $4,257,000 and $9,714,000,respectively.  Our total estimatedcapital expenditures for the next three years are $5.4 million per year, whichis contingent upon completion of financing arrangements.

 

**Electric Market**

 

In the United States, revenuesfrom sales to ultimate consumers totals over $224 billion per year.  It is an industry which is undergoing manychanges. Deregulation occurred in Texas beginning in 2002, giving rise tosignificant opportunities and challenges for the Company. Many electric utilitycompanies are significantly larger with greater resources than those of theCompany. However, a significant number of electric utilities, especiallyelectric cooperatives, are smaller in size and resources than the Company.

 

Many electric utilitycompanies, particularly small shareholder owned and cooperative electricutility businesses, may not have the size or expertise to meet the demands of anewly competitive marketplace. The Company expects that as competition becomesmore intense and operations become more complicated, more and more small tomedium sized shareholder owned and cooperative electric utility businesses willwant to divest their electric systems for some of the same reasons that theCompany’s predecessor cooperative’s membership voted to convert from a memberowned cooperative association to a shareholder owned business corporation.

 

In addition to the small tomedium sized electric utility businesses that may be looking to divest theiroperations, management believes many of the larger shareholder owned electricutilities have been cutting costs by closing service centers in smallercommunities and becoming more impersonal with their customers. Management ofthe Company believes these electric utilities are concentrating their effortsin the large urban populations and some may be looking to divest their holdingsin rural and less populated suburban areas.

 

The Company’s managementbelieves that it has the experience to consolidate these small to medium sizedelectric distribution businesses and to meet the management challenges ofsuccessfully operating these geographically diverse businesses once they havebeen acquired. The basis for this belief is that the Company has successfullycombined, and is currently operating, three former electric distributioncooperatives, which are now divisions of the Company. The most distant of thesedivisions is over 450 miles from the Company’s corporate headquarters inMidland, Texas. The Company also currently provides management services to amunicipal utility in North Texas.  See“Business-Business Strategy.”

 

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**Business Strategy**

 

The Company’s strategy involvesacquiring customers in various locations and regions across the United States,irrespective of whether those customers may be for its electric distributionbusiness or in other businesses in which the Company may engage.Notwithstanding, the Company’s experience to date has been in the electricdistribution business and it is the Company’s desire to maintain that as itsprimary business. Once deregulation comes to an area, however, the Companywants to be in a position to market a diverse set of services to itscustomers.  For this reason, the Companybelieves that an aggressive campaign of mergers and acquisitions will help itincrease its customer base and thus put it in a position to compete effectivelyin a fully deregulated marketplace.

 

At present, the Company’slargest service area is in West Texas, where it primarily serves residentialcustomers, farming and ranching customers and the oil and gas industry. In thecase of the oil and gas industry, the Company’s revenues are not significantlyaffected by normal fluctuations in the price of oil and gas.  The Company’s revenues are affected by theweather, economy and other conditions in their service areas, a circumstancethat is not unusual for a local distribution company.  The Company believes that it needs to diversify its customer baseso that it is not dependent on any one area in terms of economy and weather.The Company believes that its strategy of acquiring electric distributioncompanies in various locations and regions across the United States is the bestway for it to achieve this objective.

 

The larger electric utilitieshave traditionally been in areas with the most meters per mile of electricline. These are usually found in or around large cities and other metropolitanareas. The small to medium sized electric distribution businesses, on the otherhand, are generally located in less-populated suburban and rural areas wherethere are fewer meters per mile of electric line and where the cost of serviceper meter is therefore greater. In the past, the larger utilities have, for themost part, viewed the areas where these small to medium sized electricdistribution businesses operate as marginal because their operating areasgenerally do not provide the net revenues per dollar of investment that thelarger utilities have come to expect. The Company therefore believes that asthe electric utility industry continues to consolidate, the opportunity toacquire electric distribution businesses in less populated suburban and ruralareas will remain below the economic threshold of many of the Company’s largercompetitors, yet still provide the Company with a significant opportunity togrow and diversify.

 

The Company’s business strategyis a continuation of the Cooperative’s history of growing through acquisitions.The Cooperative acquired Lone Wolf Electric Cooperative, Inc., an electriccooperative headquartered in Colorado City, Texas, in 1991. All of the membersof Lone Wolf became members of the Cooperative. The Lone Wolf acquisition wasone of the first combinations of electric cooperatives to occur in the State ofTexas.

 

In October 1992, theCooperative acquired Hunt-Collin Electric Cooperative, Inc.  Hunt-Collin was an electric cooperativeheadquartered in Celeste, Texas, serving customers in Hunt, Collin and Fannincounties of Northeast Texas. All the members of Hunt-Collin became members ofthe Cooperative. The Hunt-Collin acquisition was the first non-contiguouscombination of cooperatives in the State of Texas and one of the first suchacquisitions in the United States.

 

In October, 1998, theCooperative entered into an agreement with the City of Farmersville, Texas, tomanage and operate its municipal electric system, including billing,collections, system improvements, power acquisition, power outages, newconstruction and normal maintenance.

 

In September 1999, theCooperative acquired McCulloch Electric Cooperative, Inc., an electriccooperative headquartered in Brady, Texas, with all of the members of McCullochbecoming members of the Cooperative.

 

In October 1999, theCooperative entered into an agreement with Lamar Electric Cooperative, Inc.(“Lamar”), pursuant to which Lamar was to combine with, and become an operatingdivision of, the Cooperative.  Themembers of Lamar subsequently approved this Combination Agreement.  The agreement provided that if thecombination was terminated by Lamar, with certain specific allowableexceptions, Lamar was required to reimburse the Cooperative for all costs andexpenses it had incurred, whether paid to outside parties or incurredinternally, with respect to the combination.

 

The completion of thecombination was delayed due to litigation with Lamar’s power supplier, RayburnCountry Electric Cooperative, Inc. (“Rayburn”).  Rayburn filed suit against Lamar and the Cooperative claimingthat each had breached various agreements. Rayburn sought and received an injunction preventing the combinationfrom going 

 

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forward. Lamar and the Cooperative also filed lawsuits against Rayburn.  The lawsuits are still pending and someclaims are currently on appeal.

 

On August 29, 2000, theCooperative and Lamar entered into a five year Management ServiceAgreement.  Under the terms of thatagreement, Lamar’s Board of Directors continued to set policy and perform allof its fiduciary responsibilities, and the Cooperative managed the day to dayoperations of Lamar and provided other services.  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 theManagement Service Agreement provided that if Lamar terminated the agreementprior to the expiration of the original term, Lamar would be required to pay acancellation fee of $300,000 as liquidated damages.

 

Lamar terminated theCombination Agreement in October 2002 and the Management Service Agreement inNovember 2002.   The Company is seekingremuneration pursuant to the terms of each of the agreements.  See “Legal Proceedings” below.

 

**I****TEM 2. PROPERTIES**

 

The West Texas transmissionsystem consists of 16 substations and 305 miles of single pole transmissionline that was constructed over a period of several years between 1975 and1995.  The system provides a loopedtransmission line at 138 kV that provides for two electric supply deliverypoints for power providers to tie into and deliver power.  All substation structures and equipment arerelatively new and utilize modern technologies.  The substations and transmission lines are controlled by aSupervisory Control and Data Acquisition (“SCADA”) system.  All present substation transformers havein-service dates between 1975 and 1995. Transmission systems normally carry high voltage electricity over longdistances, whereas distribution lines carry lower voltage power from a substationto customers.  The 16 substations supplysixty-six distribution line circuits, which serve over 11,000 miles of primaryand secondary distribution line in 17 countywide areas and suppliesapproximately 120 MW of peak electrical power. When the transmission system was being constructed, a large portion ofthe distribution system was rebuilt to accommodate the new substations, as wellas new feeder circuits being constructed with larger conductors and a higherdistribution voltage.  Many of thedistribution circuits can also be fed from alternative substations in order tominimize outage time.  The distributionsystem also utilizes a SCADA system.

 

The Company also owns a 50,000square foot office building located at 500 West Wall Street, Midland, Texas,that is used as its general corporate headquarters. The Company occupiesapproximately 30% of the building and the remainder is leased to commercialtenants. In addition to the office building, the Company owns other real estaterelated to its electric distribution business.

 

**ITEM 3. LEGAL PROCEEDINGS**

 

The Company is involved in various litigationmatters which it inherited from its predecessor cooperative, as well aslitigation since its conversion from an electric cooperative to a shareholderowned utility.

 

In September 2001, the Cooperative and theCompany filed an application to transfer the Cooperative’s certified territoryto the Company. This wasthe last step in the conversion process. Several parties intervened in thatproceeding and are seeking to stop the transfer of the CCN.  Alternatively, these Opposing Intervenorsare requesting a ruling that the Company will be regulated as a shareholderowned utility by the PUCT rather than as a cooperative.  The Public Utility Regulatory Act currentlyprovides that a successor to an electric cooperative created before June 1,1999, in accordance with a conversion plan approved by a vote of the members ofthe electric cooperative, will be considered as a cooperative for regulatorypurposes.  The Opposing Intervenorsargue that the Company does not qualify for such treatment and have attackedthe validity of the vote of the Cooperative’s members that approved theconversion process.  The OpposingIntervenors have also requested the PUCT to require the Company to “unwind” theconversion or, if it is determined that the conversion cannot be “unwound,” toregulate the Company as a shareholder owned utility for state regulatorypurposes.  As another alternative, theOpposing Intervenors seek to have restrictions placed on the Company if the CCNis transferred.  As a result, untilthere is a Final Order by the PUCT on this issue, it is uncertain whether ornot the Company will be considered a cooperative or a shareholder owned utilityfor State regulatory purposes or, if the Company is determined not to be ashareholder owned utility for state regulatory purposes, whether anyrestrictions will be placed 

 

9

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upon the Company’s operations.  Delays in receiving final approval mayimpact the Company’s timing and ability to refinance its debt.  The Company cannot predict all potentialramifications that may occur as a result of regulation by the PUC, some ofwhich could be material.  While theCompany believes it will ultimately prevail, it is impossible to predict theoutcome of these proceedings or any restrictions that the PUC may place uponthe Company.

 

A hearing was held before Administrative Law Judges inAustin, Texas, on June 17 through June 21, 2002.  Briefs were filed and the hearing was officially closed on July30, 2002. A Proposal for Decision (“PFD”) was issued by the Administrative LawJudges on September 25, 2002.  The PFDrecommended that the Company be found to have taken proper steps to qualify forcontinued treatment as a cooperative under PURA.  It further recommended that the CCN be transferred.  The PFD also recommended that the Company berequired to comply with certain conditions as part of the transfer of the CCN.  Those conditions would require the Companyto reduce its administrative and general expenses to no more than 30% of itsgross margins, prohibition from making future acquisitions that are unrelatedto providing reliable electric service to its existing customers, require anyacquisitions to first be approved by the PUC, require maintenance of separatebooks and records for its electric divisions which are distinct from itsexisting subsidiary and non-electric operations, and require filing of outagereports under PUCT Substantive Rules 25.52 and 25.81.

 

ThePFD was considered by the PUCT at an open meeting held on November 7,2002.  At the open meeting, the PUCTmade no ruling, but requested the Company and the Opposing Intervenors filebriefs in response to questions outlined by the Commissioners.  Briefs were filed and the matter was set tobe considered at another PUCT open meeting held on November 21, 2002.  At that open meeting, the PUCT made noruling, but requested an opinion from the Attorney General of the State ofTexas as to whether an electric cooperative may convert to a shareholdercorporation by transferring all of its assets and liabilities to ashareholder-owned corporation that it had created.  The Attorney General has not yet rendered an opinion.  Once the opinion from the Attorney General’soffice has been rendered, the matter will again go before the PUCT forconsideration

 

In 2002, the Company and the Cooperative filed alawsuit against some of the Intervenors in the CCN proceeding and others whoare trying to overturn the conversion plan. The Company and the Cooperative are seeking a declaratory judgment andother relief in that none of the defendants, nor any other person or entity,has standing to challenge the Cooperative’s “conversion” by transferring all ofits assets and liabilities to the Company. The lawsuit is in the early discovery stages and while it is impossibleto predict the outcome at this time, the Company believes it has adequate legalstanding to prevail with regard to the validity of its claims.

 

InOctober 1999, the Cooperative entered into an agreement with Lamar, pursuant towhich Lamar was to combine with, and become an operating division of, theCooperative.  The members of Lamarsubsequently approved this Combination Agreement.   The agreement provided that if the combination was terminated byLamar, with certain specific allowable exceptions, Lamar was required toreimburse the Cooperative for all costs and expenses it had incurred, whetherpaid to outside parties or incurred internally, with respect to thecombination.

 

Thecompletion of the combination was delayed due to litigation with Lamar’s powersupplier, Rayburn Country Electric Cooperative, Inc. (“Rayburn”).  Rayburn filed suit against Lamar and theCooperative claiming that each had breached various agreements.  Rayburn sought and received an injunctionpreventing the combination from going forward. Lamar and the Cooperative also filed lawsuits against Rayburn.  The lawsuits are still pending and someclaims are currently on appeal.

 

OnAugust 29, 2000, the Cooperative and Lamar entered into a five year ManagementService Agreement.  Under the terms ofthat agreement, Lamar’s Board of Directors continued to set policy and performall of its fiduciary responsibilities, and the Cooperative managed the day today operations of Lamar and provided other services.  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 theManagement Service Agreement provided that if Lamar terminated the agreementprior to the expiration of the original term, Lamar would be required to pay acancellation fee of $300,000 as liquidated damages.

 

Lamar terminated theCombination Agreement in October 2002 and the Management Services Agreement inNovember 2002.  The Company believesthat Lamar’s stated reason for termination of the Combination Agreement doesnot fall within the specific allowable exceptions set forth in the agreement,and therefore the Company believes it is 

 

10

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entitled to reimbursement of all costs andexpenses incurred.  Outside legal andconsulting fees of approximately $1,357,000 were incurred, as well as otherrecoverable costs.  The Company hasassessed its rights under the agreement and believes it is entitled toreimbursement for all costs and expenses. The Company is currently compiling that data in order to determine thetotal recoverable costs it will seek under the provisions of the CombinationAgreement.  The Company is also seekingthe cancellation fee of $300,000 pursuant to the terms of the ManagementService Agreement, which it believes it is entitled to recover.

 

Because Lamar terminated theCombination Agreement, SFAS No. 141 required the impairment of those outsidelegal and consulting costs of $1,357,000, until reimbursement is actuallyreceived from Lamar.  Therefore theconsolidated results of operations reflect such expense for the year endedDecember 31, 2002, with those costs as of December 31, 2001, aggregating$956,000 shown in Deferred credits on the balance sheet.

 

The above matters arecurrently the subject of a lawsuit in the 62nd District Court in Lamar County,Texas.

 

In March 2002, the Cooperative received a demandletter from an attorney claiming to represent members or shareholders of theCooperative. Such letter purports to be a derivative action demand underArticle 5.14 section C of the Texas Business Corporation Act. The lettergenerally asserts wrongdoing by the Board and management because the vote atthe October 20, 1998, membership meeting at which the conversion plan wasadopted was not a valid vote. The Cooperative believes the claims outlined inthe letter have no merit and responded accordingly to the letter.  No further demands have been received and nolegal action has been taken.

 

Other than certain legal proceedings arising inthe ordinary course of business and the aforementioned legal matters, there isno other litigation pending or threatened against the Company.  As discussed in “Notes to the ConsolidatedFinancial Statements” included herein, none of this litigation is expected tohave a material impact on the Company’s financial condition, operating resultsor liquidity.

 

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

 

The Annual Meeting ofShareholders was held on December 2, 2002. The following proposals were adopted by the margins indicated:

 

1.       To elect two directors to hold officeuntil 2005

 
|                 |   | **Number of Shares** |   |
|----------------------|--------|----------------------|--------|
|                 |   | **For**              |   | **Against** |   |
| Michael D. Schaffner |   | 546,040              |   | 7,048 |   |
| Newell W. Tate       |   | 545,746              |   | 7,342 |   |

 

2.               To approve Amendments to the CapRock Energy Corporation Employee Stock Purchase Plan

 
| For             |   | 444,251 |   |
|-----------------|--------|---------|--------|
| Against         |   | 7,161   |   |
| Abstain         |   | 33,491  |   |
| Broker non-vote |   | 68,185  |   |

 

 

3.               To approve amendments to the CapRock Energy Corporation Stock Incentive Plan

 
| For             |   | 439,454 |   |
|-----------------|--------|---------|--------|
| Against         |   | 6,794   |   |
| Abstain         |   | 38,655  |   |
| Broker non-vote |   | 68,185  |   |

 

11

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4.               To approve the Cap Rock EnergyCorporation Stock for Compensation Plan

 
| For             |   | 436,740 |   |
|-----------------|--------|---------|--------|
| Against         |   | 7,721   |   |
| Abstain         |   | 40,442  |   |
| Broker non-vote |   | 68,185  |   |

 

5.               To ratify the appointment of KPMGLLP as independent public accountants for 2002

 
| For             |   | 543,376 |   |
|-----------------|--------|---------|--------|
| Against         |   | 4,084   |   |
| Abstain         |   | 5,628   |   |
| Broker non-vote |   | -0-     |   |

 

**Executive Officers of the Registrant**

 

The executive officers of the Company are asfollows:

 
| **NAME**           |   | **AGE** |   | **POSITION**                                                     |
|--------------------|--------|---------|--------|------------------------------------------------------------------|
| David W. Pruitt    |   | 56      |   | Co-Chairman of the Board,  President and Chief Executive Officer |
|               |   |    |   |                                                             |
| Ulen A. North. Jr. |   | 58      |   | Executive Vice President                                         |
|               |   |    |   |                                                             |
| Lee D. Atkins      |   | 59      |   | Senior Vice President, Chief  Financial Officer and Treasurer    |
|               |   |    |   |                                                             |
| Sammy C. Prough    |   | 52      |   | Vice President and Chief  Operating Officer                      |
|               |   |    |   |                                                             |
| Ronald W. Lyon     |   | 47      |   | Vice President, General  Counsel and Secretary                   |
|               |   |    |   |                                                             |
| Celia A. Zinn      |   | 54      |   | Vice President, Controller  and Assistant Secretary/Treasurer    |

 

*•**                                         **David W. Pruitt* has served as President and ChiefExecutive Officer of the Company since its inception.  Mr. Pruitt also served as the President and Chief ExecutiveOfficer of the Cooperative from August 1987 until inception of the Company.

 

*•**                                         **Ulen A. North Jr*. has served as Executive VicePresident of the Company since its inception. He served the Cooperative in various positions from March 1969, andserved as Executive Vice President of the Cooperative since December 1996 untilinception of the Company.

 

*•**                                         **Lee D. Atkins* has served as Senior Vice Presidentand Chief Financial Officer of the Company since September 2001. He served asExecutive Vice President/Chief Financial Officer of RedMeteor.com, Inc. from August2000 until September 2001, and as Vice President/CFO of CSW Energy fromFebruary 1992 until August 2000.

 

*•**                                         **Sammy C*. *Prough*hasserved as Vice President and Chief Operating Officer of the Company since itsinception.  Mr. Prough served theCooperative in various positions since April 1974, including Systems Managerfrom October 1996 to June 1999 and Vice President and Chief Operating Officersince June 1999 until inception of the Company.

 

*•**                                         **Ronald W*. *Lyon*has served as Vice President and General Counsel of the Company since October2001. Mr. Lyon, who has been engaged in the private practice of law formore than the past five years, served as full-time general counsel to theCooperative since 1993 until inception of the Company.

 

*•**                                         **Celia A. Zinn* joined the Company as Controller inJuly 2001, and was elected to serve as Assistant Secretary/Treasurer in August2002, and Vice President in December 2002. She previously served as Senior Vice 

 

12

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President and Controller ofCostilla Energy, Inc. from April 1996 until July 2001.  Ms. Zinn is a certified public accountant.

 

**PART II**

 

**ITEM5.  MARKET FOR REGISTRANT’S COMMONEQUITY AND RELATED STOCKHOLDER MATTERS**

 

**Price Range and Holders of Common Stock**

 

The Company’s common stock islisted on the American Stock Exchange under the symbol “RKE.” The Company’scommon stock was initially issued on February 8, 2002, and began trading on theAmerican Stock Exchange on March 14, 2002.  The following table sets forth the range of high and low sales pricesper share of common stock for the periods indicated, as reported on theAmerican Stock Exchange.  Because thestock was not issued and distributed to former members of the Cooperative untilFebruary 8, 2002, and the stock was not listed on the AMEX until March 14,2002, there was no previous market for the shares.

 

| **Quarter Ended:** |   | **High** |   | **Low** |   |
|--------------------|--------|----------|--------|---------|--------|
| December 31, 2002  |   | $        | 11.65  |    | $      | 10.10 |   |
| September 30, 2002 |   | 12.35    |   | 11.25   |   |
| June 30, 2002      |   | 12.60    |   | 7.20    |   |
|                    |        |          |        |         |        |  |  |

 

As of March 24, 2003, therewere 13,744 record holders of the 1,302,355 shares of the Company’s commonstock.

 

**Dividend Policy**

 

Holders of the Company’s commonstock are entitled to dividends if, as and when declared by the Board ofDirectors out of funds legally available therefore, subject to prior rights ofholders of any outstanding cumulative preferred stock. The Company has not declared orpaid dividends on its common stock to date, and does not anticipate payingdividends in the foreseeable future.  TheCompany’s loan documents with CFC place certain restrictions on the payment bythe Company of dividends.  At thepresent time, the Company has not issued preferred stock.

 

**SecuritiesAuthorized for Issuance under Equity Compensation Plans**

 

The following table setsforth certain information regarding the Company’s equity compensation plans asof December 31, 2002:

 
| **Plan Category**                                           |   | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights********(a)** |   | **Weighted average********exercise********price of outstanding  options, warrants and  rights********(b)** |   | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a)) (c)** |   |
|-------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Equity  compensation plans approved by security holders     |   | —                                                                                                        |   | —                                                                                                     |   | 1,300,000                                                                                                                                                 |   |
| Equity  compensation plans not approved by security holders |   | —                                                                                                        |   | —                                                                                                     |   | —                                                                                                                                                    |   |
| Total                                                       |   | —                                                                                                        |   | —                                                                                                     |   | 1,300,000                                                                                                                                                 |   |

 

13

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**ITEM6.  SELECTED FINANCIAL DATA**

 

**SELECTED CONSOLIDATED FINANCIAL DATA**

 

The following table sets forthselected consolidated financial statement information for the year endedDecember 31, 2002, nine month periods ended December 31, 2001 and 2000, and foreach of the three years in the three year period ended March 31, 2001. TheConsolidated Statements of Operations, Balance Sheet and Cash Flows Data forthe year ended December 31, 2002, nine months ended December 31, 2001 and 2000,and as of the end of each of the years in the three year period ended March 31,2001, are derived from the Consolidated Financial Statements of the Company.The following selected consolidated financial data should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and the Consolidated Financial Statements, includingthe Notes thereto, appearing elsewhere herein.

 
|                                                                |   | **YEAR  ENDED  DECEMBER  31,**                                                                                                                 |   | **NINE MONTHS ENDED********DECEMBER 31,** |   | **YEARS ENDED MARCH 31,** |   |
|---------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|---------------------------|--------|
|                                                                |   | **2002**                                                                                                                                       |   | **2001 (3)**                              |   | **2000**                  |   | **2001** |   | **2000(1)** |   | **1999** |   |
|                                                                |   |                                                                                                                                           |   |                                      |   | **(UNAUDITED)**           |   |   |   |   |   |   |   |
|                                                                |   | ** - - - -  - - - - -- - - - - - - - - - - - - - - - - - - (Thousands of dollars)- - - -  - - - - - - - - - - - - - - - - - - - - - - -** |   |
|                                                                |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
| **CONSOLIDATED  STATEMENT OF********OPERATIONS DATA:**              |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
|                                                                |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
| Operating  revenues                                                 |   | $                                                                                                                                              | 74,637 |                                      | $      | 53,122                    |   | $ | 52,100 |   | $ | 72,465 |   | $ | 56,391 |   | $ | 54,803 |   |
| Operating  expenses                                                 |   | (59,964                                                                                                                                        | )      | (43,142                                   | )      | (50,101                   | )      | (68,144 | ) | (51,773 | ) | (49,193 | ) |
| Operating  income                                                   |   | 14,673                                                                                                                                         |   | 9,980                                     |   | 1,999                     |   | 4,321 |   | 4,618 |   | 5,610 |   |
| Other  income (expense)                                             |   | (5,483                                                                                                                                         | )      | (5,580                                    | )      | (6,884                    | )      | (9,471 | ) | (10,357 | ) | (5,223 | ) |
| Income  (loss) before income taxes                                  |   | 9,190                                                                                                                                          |   | 4,430                                     |   | (4,885                    | )      | (5,150 | ) | (5,739 | ) | 387 |   |
| Income  tax expense                                                 |   | 414                                                                                                                                            |   | —                                    |   | —                    |   | — |   | — |   | — |   |
| Income  (loss) before extraordinary item                            |   | 8,776                                                                                                                                          |   | 4,430                                     |   | (4,885                    | )      | (5,150 | ) | (5,739 | ) | 387 |   |
| Extraordinary  item–  Gain on early extinguishment of debt (2) |   | —                                                                                                                                         |   | —                                    |   | 969                       |   | 969 |   | — |   | — |   |
| Net  income (loss)                                                  |   | $                                                                                                                                              | 8,776  |                                      | $      | 4,430                     |   | $ | (3,916 | ) | $ | (4,181 | ) | $ | (5,739 | ) | $ | 387 |   |
|                                                                |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
| **PRO FORMA BASIC AND  DILUTED EARNINGS PER SHARE (UNAUDITED):**    |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
|                                                                |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
| Income  (loss) from continuing operations                           |   |                                                                                                                                           |   | $                                         | 3.40   |                      |   |   | $ | (3.95 | ) |   |   |   |   |
| Extraordinary  item (2)                                             |   |                                                                                                                                           |   | —                                    |   |                      |   | 0.74 |   |   |   |   |   |
| Net  income (loss)                                                  |   |                                                                                                                                           |   | $                                         | 3.40   |                      |   |   | $ | (3.21 | ) |   |   |   |   |
| Pro  forma shares outstanding                                       |   |                                                                                                                                           |   | 1,302,355                                 |   |                      |   | 1,302,355 |   |   |   |   |   |
|                                                                |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
| **BASIC AND DILUTED  EARNINGS PER SHARE:**                          |   |                                                                                                                                           |   |                                      |   |                      |   |   |   |   |   |   |   |
| Net  income                                                         |   | $                                                                                                                                              | 6.74   |                                      |   |                      |   |   |   |   |   |   |   |   |
| Shares  outstanding                                                 |   | 1,302,355                                                                                                                                      |   |                                      |   |                      |   |   |   |   |   |   |   |

 
|                                  |   | **DECEMBER 31,**                                                                                                                                    |    | **MARCH 31,** |   |
|---------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|---------|---------------|--------|
|                                  |   | **2002**                                                                                                                                            |    | **2001**      |   | **2000** |   | **2001** |   | **2000** |   | **1999** |   |
|                                  |   |                                                                                                                                                |    |          |   | **(UNAUDITED)** |   |   |   |   |   |   |   |
|                                  |   | ** - - - -  - - - - - - - - - - - - - - - - - - - - - - - - - (Thousands of dollars) - -  - - - - - - - -- - - - - - - - - - - - - - - - - -** |    |
|                                  |   |                                                                                                                                                |    |          |   |   |   |   |   |   |   |   |   |
| **CONSOLIDATED  BALANCE SHEET DATA:** |   |                                                                                                                                                |    |          |   |   |   |   |   |   |   |   |   |
|                                  |   |                                                                                                                                                |    |          |   |   |   |   |   |   |   |   |   |
| Utility  plant, net                   |   | $                                                                                                                                                   | 157,323 |          | $      | 164,547 |   | $ | 170,111 |   | $ | 168,920 |   | $ | 169,537 |   | $ | 155,567 |   |
| Total  assets                         |   | 211,294                                                                                                                                             |    | 214,459       |   | 218,382 |   | 221,195 |   | 200,881 |   | 181,983 |   |
| Equity  and margins                   |   | —                                                                                                                                              |    | 7,672         |   | 6,012 |   | 5,675 |   | 12,659 |   | 19,245 |   |
| Long-term  debt, net                  |   | 148,052                                                                                                                                             |    | 181,732       |   | 184,688 |   | 188,627 |   | 140,333 |   | 125,625 |   |
| Stockholders’  equity            |   | 14,738                                                                                                                                              |    | —        |   | — |   | — |   | — |   | — |   |
|                                  |   |                                                                                                                                                |    |          |   |   |   |   |   |   |   |   |   |
| **CONSOLIDATED CASH  FLOWS:**         |   |                                                                                                                                                |    |          |   |   |   |   |   |   |   |   |   |
| Net  cash provided by (used) in:      |   |                                                                                                                                                |    |          |   |   |   |   |   |   |   |   |   |
| Operating  activities                 |   | 13,250                                                                                                                                              |    | 11,257        |   | 5,732 |   | 7,022 |   | 7,200 |   | 8,674 |   |
| Investing  activities                 |   | 526                                                                                                                                                 |    | (2,233        | )      | (23,867 | ) | (23,414 | ) | (14,124 | ) | (10,004 | ) |
| Financing  activities                 |   | (9,375                                                                                                                                              | )       | (9,262        | )      | 17,423 |   | 20,597 |   | 7,065 |   | 1,382 |   |
|                                       |        |                                                                                                                                                     |         |               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

14

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(1)                                  TheCooperative acquired McCulloch Electric Cooperative, Inc. (“McCulloch”)effective September 1, 1999. McCulloch’s operations subsequent to theacquisition are included in the consolidated statement of operations.

(2)                                  Asdiscussed in Note 13 to the consolidated financial statements included herein,substantially all of the McCulloch long-term debt was refinanced resulting inan extraordinary gain on early extinguishment of debt of $969,000.

(3)                                  TheCompany changed its year-end from March 31 to December 31, effective December31, 2001.

 

**ITEM7.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Cautionary Statement RegardingForward-Looking Statements**

 

In the interest of providingthe shareholders with certain information regarding the Company’s future plansand operations, certain statements set forth in this Form 10-K relate tomanagement’s future plans and objectives. This Form 10-K contains statements that are “forward-looking statements”under the Private Securities Litigation Reform Act of 1995.  All statements other than statements ofhistorical facts included in this report, including, without limitation,statements regarding the Company’s future financial position, businessstrategy, budgets, projected costs and plans and objectives of management forfuture operations, are forward-looking statements.   In addition, forward-looking statements generally can beidentified by the use of forward-looking terminology such as “may,” “will,”“expect,” “intend,” “project,” “estimate,” “anticipate,” “believe,” or “continue”or the negative thereof or similar terminology.  Although any forward-looking statements contained in this Form10-K or otherwise expressed by or on behalf of the Company are, to theknowledge and in the judgment of the officers and directors of the Company,believed to be reasonable, there can be no assurances that any of theseexpectations will prove correct or that any of the actions that are plannedwill be taken.  Forward-lookingstatements involve known and unknown risks and uncertainties, which may causethe Company’s actual performance, and financial results in future periods todiffer materially from any projection, estimate or forecasted result.  Important factors that could cause actualresults to differ materially from the Company expectations include the effectsof deregulation and related proceedings, weather, the cost of purchased powerand related fuel costs.   All subsequentwritten and oral forward-looking statements attributable to the Company, orpersons acting on its behalf, are expressly qualified in their entirety by theCautionary Statements.  The Companyassumes no duty to update or revise its forward-looking statements based onchanges in internal estimates or expectations.

 

The following discussion andanalysis of the Company and its Predecessor’s financial condition and resultsof operations for the years ended December 31, 2002 and 2001, and the ninemonths ended December 31, 2001 and 2000, should be read in conjunction with theCompany’s audited consolidated financial statements and related notes tofinancial statements included elsewhere in this document.

 

**Overview**

 

Cap Rock Energy Corporation isan electric distribution company operating in various non-contiguous areas inthe State of Texas. The Company provides service to over 35,000 meters in 28counties in Texas. This includes 23,000 meters in 17 counties in theMidland-Odessa area of West Texas, 6,100 meters in the Central Texas areaaround Brady, Texas, and over 4,200 meters in Northeast Texas in Hunt, Collinand Fannin Counties. The Company also provides management services to theFarmersville Municipal Electric System which services nearly 1,700 meters inFarmersville, Texas.

 

The Company purchases power forresale to its retail customers from wholesale suppliers and distributes thatpower to its customers over transmission lines covering over 320 miles and thenover 11,000 miles of distribution lines. The Company has not and does not planto engage in the generation of electricity. The Company’s primary focus is on thedistribution of electricity to its customers. In 2002, the Company purchasedall electric power pursuant to wholesale electric power contracts withSouthwestern Public Service Company, Dynegy Power Marketing, Inc., LowerColorado River Authority and Garland Power and Light. Generally, the wholesaleelectric power supply contracts are based on fixed charges for kWh usage,transportation and auxiliary services and a variable charge for fuel based onkWh usage. The Company’s purchased power costs fluctuate primarily with theprice of natural gas. However, all costs associated with purchased power arepassed through to the retail customer.

 

15

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The Board of Directors adopteda resolution changing the date of the Company’s and the Cooperative’s fiscalyear end from March 31 to December 31, effective for the year ended December31, 2001.

 

**CriticalAccounting Policies and Estimates**

 

The Company’s significantaccounting policies are in Note 1 to the consolidated financialstatements.  Certain of our accountingpolicies require the application of significant judgment by management inselecting the appropriate assumptions for calculating financial estimates.  By their nature, these judgments are subjectto an inherent degree of uncertainty. These judgments are based on our historical experience, terms ofexisting contracts, our observance of trends in the industry, informationprovided by our customers, and information available from other outsidesources, as appropriate.  Differentestimates reasonably could have been used in the current period, or changes inthe accounting estimates are reasonably likely to occur from period to period,that could have a material impact on the presentation of the Company’sfinancial condition, changes in financial condition or results ofoperations.  We believe that thefollowing financial estimates are both important to the portrayal of theCompany’s financial condition and results of operations and require subjectiveor complex judgments.  Further, webelieve that the items discussed below are properly recorded in the financialstatements for all periods presented. Management has discussed the development, selection and disclosure ofour most critical financial estimates with the Board of Directors’ AuditCommittee.

 

The Company’s mostsignificant accounting policies are described in Note 1 to the consolidatedfinancial statements.  The Company’smost critical accounting policy involves rate regulation.  The Company is subject to the provisions ofFinancial Accounting Standards Board (“SFAS”) Statement No. 71, “Accounting forthe Effects of Certain Types of Regulation.” In certain circumstances, SFAS No. 71 requires that certain costs and/orobligations be reflected in a deferral account on the balance sheet and notreflected in the statement of income or loss until matching revenues arerecognized.  It is the Company’s policyto assess the recoverability of costs recognized as regulatory assets andCompany’s ability to continue to account for its activities in accordance withSFAS No. 71, based on each regulatory action and the criteria set forth in SFASNo. 71.

 

*Allowance for doubtful accounts.*  Whenevaluating the adequacy of our allowance for doubtful accounts, managementanalyzes accounts receivable, historical bad debts, customer credit-worthiness,current customer payment performance and current economic trends.  For the year ended December 31, 2002, ninemonths ended December 31, 2001 and year ended March 31, 2001, the bad debt expensewas less than one tenth of one percent of electric sales in each respectiveyear.

 

Our accounts receivablebalance was $4,723,000 and $3,642,000, net of allowance for doubtful accountsof $50,000 and $202,000, at December 31, 2002 and 2001, respectively.

 

*Power Cost Recovery Factor.*  Thepower cost recovery factor is the difference between the cost of purchasedpower and the cost recovered from the customers, divided by the number ofkilowatt hours billed during the period. This factor is estimated each month to recover actual costs and is addedto the base rate.  The factor is basedon estimates of power cost increases/decreases due to increases/decreases infuel cost, usage and other cost fluctuations. The estimate is adjusted in the subsequent month as compared to actualactivity.

 

*Derivative Instruments and Hedging Activities. *The Company enters into derivative transactions to manage the cost ofnatural gas as the fuel component of power cost.  As described in note 1 to the consolidated financial statements,the pricing under the Company's various power contracts varies with fuel cost,which is generally determined by the cost of natural gas.  These transactions minimize the fluctuationsin their customers’ power bills.  Theinstruments are measured at fair market value and recorded as an asset orliability with a corresponding regulatory asset or liability.  Changes in the fair value are recognized incurrent earnings unless specific hedge accounting criteria are met.

 

*Revenue Recognition Policy. *For allperiods through December 31, 2002, the Company and its predecessor, theCooperative, utilized the cycle billing method to recognize revenue, pursuantto the rate-making policy as set by the Board of Directors.  The cycle billing method recognizes revenueon an “as billed basis” which recognizes revenue when the customer is billedand not on an accrual basis, which recognizes revenue as the power isdistributed to the customer.  Byutilizing the “as billed” method, unbilled revenue is not recognized.  In the utility industry, the rate-makingpolicy defines the accounting requirements according to SFAS No. 71,“Accounting for the Effects of Certain Types of Regulations.”

 

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Effective January 1, 2003, theCompany’s Board of Directors changed the rate-making policy to recognizeunbilled revenue.  At such time, theCompany will be required to change accounting principles related to its revenuerecognition method.  Under the newrate-making structure, the Company will recognize revenue when power isdistributed to the customer rather than when the customer is billed.

 

**Results ofOperations**

 

**Year ended December 31, 2002Compared With Year Ended December 31, 2001**

 

*Net Income (Loss)*

 

For the year ended December31, 2002, net income was $8,776,000 as compared to net income of $4,834,000 forthe year ended December 31, 2001, an increase of $3,944,000.  The majority of the increase is due to:

 

•                  An increase in operating revenues of $1.2million;

•                  A net decrease in operating expenses of $0.7million;

•                  A net decrease in other income (expense) of$2.4 million; offset by

•                  An increase in tax expense of $0.4 million.

 

*Operating Revenues*

 

Operating revenues for theyear ended December 31, 2002, were $1,226,000 greater than those of the yearended December 31, 2001.  The increasewas due to the recognition of revenue related to the recovery of power cost,offset by a slight decrease in electric sales.

 

*Operating Expenses*

 

Operating expenses for 2002and 2001, were $59,964,000 and $60,721,000, respectively, a decrease of$757,000, for the following reasons:

 

Purchased power costdecreased by $4.3 million due to high natural gas prices and fixed pricecontract losses during the early months of 2001.  Natural gas prices affect the cost of power generation, which ispassed through from our power suppliers. The decrease in purchase power cost was offset by an increase in generaland administrative expense of $2.5 million and further offset by $1.3 millionfor the write off of deferred costs related to the termination of the Lamarcombination.  The increase in generaland administration expense was primarily due to legal expenses associated withPUCT hearings, discussed in “Legal Proceedings,” and shareholder related costs.

 

*Other Income (Expense)*

 

Interest expense decreasedby $3.7 million offset by a decrease in other income items of $1.3million.  Interest expense decreased dueto a decline in variable interest rates. Long-term variable rates were 3.4% in December 2002 compared to 4.7% inDecember 2001.  The line of creditinterest rates were 3.65% and 5.1% for December 2002 and December 2001,respectively.

 

*Income Taxes*

 

Current income tax expensewas $414,000 in 2002.  There was nocurrent income tax expense in 2001 due to utilization of net operating losscarryforwards.  Prospectively, astrategy is available to defer a portion of income tax expense.

 

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**Nine Months Ended December 31, 2001 ComparedWith Nine Months Ended December 31, 2000**

 

*Net Income (Loss)*

 

For the nine months ended December 31, 2001, netincome was $4,430,000 as compared to net loss of $3,916,000 for the nine monthsended December 31, 2000, an increase in net income of $8,346,000. The majorityof the increase is due to:

 

•                  increase in revenues from electric sales of$1,674,000;

•                  decrease in the cost of purchased power by$4,185,000; and

•                  one time write offs of investments in 2000 for$3,878,000

 

*Operating Revenues*

 

Operating revenues for the nine months endedDecember 31, 2001, were $53,122,000 compared to $52,100,000 for the same periodin 2000. The increase is attributable to rate increases for electric kWh salesand income recognition of $1.7 million associated with the recovery of powercost. The increases were partially offset by a 3% decrease in kWh sales toresidential and commercial customers due to a milder summer.

 

*Operating Expenses*

 

Operating expenses for 2001 and 2000, were$51,146,000 and $58,004,000, respectively, a decrease of $6,858,000, (11.8%)for the following reasons:

 

Purchased power costs decreased by $4,185,000(12.9%) between the nine month periods, from $32,379,000 in 2000, to$28,194,000 in 2001. The decrease is due to lower natural gas prices for powergeneration, which is passed through from our purchase power providers.

 

Operations and maintenance expense increased$344,000 (19%) between the two periods because of increased maintenanceactivities due to of the effects of weather damage (lightning in the latespring). Additionally, a preventive maintenance program was initiated in thespring of 2001.

 

Administrative and general expenses for the ninemonth period ended December 31, 2001, increased by $767,000 a 30% increase,over the comparable period in 2000. This was due to increased legal expensesassociated with the transfer of the CCN, use of consultants for short-termprojects, internal costs associated with the conversion process and thefulfillment of staffing needs relating to deregulation of electric utilitiesand filing requirements with the SEC.

 

The Company wrote off two investments during theyear 2000: $2,815,000 was related to the Citizens transaction and $1,063,000was written off for the investment in MDC. See Notes 6 and 7 to “Notes toConsolidated Financial Statements.” No write offs were recognized for the ninemonths ended December 31, 2001.

 

*Operating Income*

 

The nine months ended December 31, 2001, reflectedoperating income of $9,980,000, as compared to the same nine month period in2000, which had operating income of $1,999,000. This resulted in an increase inoperating income of $7,981,000. The increase was primarily attributable to theincrease in sales and the decrease in operating expenses discussed above.

 

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*Other Income (Expense)*

 

Other income for the nine months ended December31, 2001, was $5,580,000 compared to $6,884,000 for the nine months endedDecember 31, 2000. The increase was primarily attributable to:

 

•                      A $385,000 increase in dividends from associatedorganizations; and

•                      $962,000 increase in interest income

 

Interest income, generated by a new notereceivable, accounted for a large part of the increase. Other miscellaneousservices provided to customers also contributed.

 

*Extraordinary Items*

 

As discussed in Note 13 to the consolidatedfinancial statements, the Cooperative paid off certain long-term debt during2000, resulting in an extraordinary gain of $969,000 on early extinguishment ofdebt.

 

**Liquidity and Capital Resources**

 

As of December 31, 2002 , the Company had:

 

•                                          Cash and cashequivalents of $9,899,000;

•                                          A working capitaldeficit of $4,555,000; and

•                                          Long-term indebtednessof $148,052,000, net of current portion.

 

Historically, the Company’s primary sources ofliquidity have been cash flows from operations and borrowings from CFC, theCompany’s primary lender. These borrowings are collateralized by substantiallyall of the Company’s utility distribution assets. The existing long-term debtconsists of a series of loans from CFC that impose various restrictivecovenants, including the prohibition of additional secured indebtedness, or theguaranty of such, and requires the maintenance of a debt service coverage ratioas defined in the CFC loan agreements. In addition, the Company may not makeany cash distribution or any general cancellation or abatement of charges forelectric energy or services to its customers if the ratio of equity to totalassets is less than a stated percentage. At December 31, 2002, the Company wasin compliance with its CFC loan agreements or had obtained waivers of certaincovenants therein that the Company was required to meet.

 

As of December 31, 2002, the Company had utilizedall available borrowing capacity under the CFC loan agreements. Historically,the majority of the Company’s distribution property additions have beenfinanced with long-term borrowings from CFC. In order for the Company to meetits working capital needs, debt service requirements, common stock purchasecommitments and planned capital expenditures, the following options may beavailable:

 

•                                          Securing new financing;

•                                          Reducing short-termcapital expenditures

•                                          Selling orcollateralizing non-strategic assets; and

•                                          Refinancing existingdebt obligations.

 

Additionally, effective December 1, 2002, theCompany converted its existing long-term debt from variable interest rates toone-year, two-year and three-year fixed rates in order to minimize its interestrate exposure.  Interest rates werefixed for the next three years at rates under 5%.   Approximately 10% of the note balances were fixed for one year,60% for two years and 30% for 3 years.

 

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TheCompany has debt service payment obligations for the next 12 months assummarized below:

 
|                    |   | **Quarter ended**   |   |
|-------------------------|--------|---------------------|--------|
|                    |   | **March 31,  2002** |   | **June 30,  2002** |   | **September 30,  2003** |   | **December 31,  2003** |   |
|                    |   |                |   |   |   |   |   |   |   |
| Long-term debt payments |   | $                   | 1,121  |   | $ | 1,129 |   | $ | 13,026 |   | $ | 893 |   |
| Capital lease payments  |   | 1,338               |   | 1,376 |   | 15,008 |   | 33 |   |
| Total cash commitments  |   | $                   | 2,459  |   | $ | 2,505 |   | $ | 28,034 |   | $ | 926 |   |

 

CFC has approved theconversion of the prior line of credit for $28 million to a five year termloan.  The terms of the new arrangementinclude quarterly payments of approximately $233,000 based on a 30 year amortizationschedule with a final balloon payment at the end of year five, initialprincipal payment deferral of one year and a fee of $210,000.  The execution of the new loan documents iscurrently in progress.  The $28 millionterm loan is not included in the above table due to deferral of any principalpayments until 2004.

 

The Company anticipatesreceipt of payment for the United Fuel notes receivable balance ofapproximately $11.9 million prior to the scheduled maturity date because UnitedFuel is currently in discussions with lenders in order to obtain financing thatwould provide funds to allow United Fuel to fully repay the Company’s notesreceivable.  See Note 15 to theconsolidated financial statements. These proceeds will be used to satisfy the cross-collateralized note payableof the same amount included in the table above under long-term debtpayments.  The maturity date for boththe notes receivable and note payable is in the third quarter of 2003.  If United Fuel is not successful inobtaining financing, the Company has other options available to obtain thefunds necessary to satisfy its debt obligations.  Also, in the event United Fuel is not successful in obtainingfinancing, United Fuel, or its shareholders who have provided the Company withpersonal guarantees of the notes receivable, would pay down the notes andprovide funds to the Company such that the Company would together with its cashflow from operations, be able to satsify its debt obligations as they becomedue in 2003.  The Company is alsoconsidering, as an alternative, an opportunity to extend the payment date ofthe note payable to the bank for $12,490,000 for an additional year.

 

The Company believes cashgenerated from normal operations will be sufficient to service the remainingdebt obligations listed in the table above, which includes the transmissionsystem capital lease balloon payment of approximately $14 million due in thethird quarter of 2003.  This capitallease balloon payment will be offset by sinking fund monies which willapproximate $8 million at September 2003. The current sinking fund balance of approximately $7.4 million isreflected in Other current assets.

 

One of the Company’ssubsidiaries, NewCorp Resources Electric Cooperative, Inc., owns a 305 miletransmission system in West Texas.  Eventhough, as described above, there is sufficient cash flow to satisfy debtobligations, the Company is attempting to either refinance or sell thistransmission system and has received various proposals to do so.  The decision on which alternative best suitsthe Company’s needs will be based upon various factors such as the amount ofsale or loan proceeds, documentation requirements, the regulatory approvalprocess and management approval.  Anyproposed transaction would be subject to several conditions, including:

 

•                                          Approval of thetransaction by the Company’s Board of Directors and the appropriate managementof the buyer or lender;

•                                          Completion of any duediligence reviews;

•                                          Execution by the partiesof definitive agreements and all other necessary agreements; and

•                                          Approval of regulatoryagencies having jurisdiction over the transmission system, if applicable ornecessary.

 

At the closing, funds wouldbe used to repay all amounts owed with respect to the original transmissionline financing, to fund any capital investment needs and to satisfy generalcorporate needs such as reserves for storm damage.

 

As discussed above in “LegalProceedings” and in Note 26 to the consolidated financial statements, theCooperative and the Company filed an application to transfer the Cooperative’scertified territory to the Company. This was the last step in the conversion process.  The Company’s current ongoing negotiationsto refinance the transmission system through a loan or sale could be delayed orinterrupted due to the above mentioned issues relative to the PUCT and the CCN.

 

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Commencing one year from the date of the distribution ofthe Company’s common stock to the former members of the Cooperative in connectionwith the conversion plan and ending 60 days thereafter, the Company offered topurchase at a price of $10 per share all of its shares of common stock thatwere distributed in connection with the Plan. The effect of the common stockpurchase commitment is unknown because it is based on the number ofshareholders who accept the offer. Shares of the Company’s common stock were originally distributed tocertain former members of the Cooperative who elected to receive shares ofstock as payment for their equity and membership interest in theCooperative.  Pursuant to the terms ofthe conversion plan, the Company made a commitment to purchase those shares,held continuously by the original owners of record until the first anniversaryof the distribution of the shares at a price of $10 per share if the Companyhad sufficient cash available to purchase all shares tendered.  The Company’s original purchase commitmentwas only to thoseshareholders who were the original holders of record, and who had held those sharescontinuously until the first anniversary of the distribution of the shares.  In aneffort to be inclusive, rather than exclusive, the Company has made the offerto all shareholders and extended the offering period beyond the original 60days.  The offering period beganFebruary 5, 2003, and will end April 30, 2003.

 

Ifall shareholders tendered their shares, the maximum amount of funds requiredwould be $13,023,550.  The Companycurrently has cash available from its operations of $550,000 with which topurchase tendered shares.  Whileadditional cash from operations may become available, the Company does notbelieve substantially more than 55,000 shares will be tendered.  If the number of shares tendered exceeds theCompany’s cash available to purchase all shares tendered at that time, theCompany may extend the offer once in order to try to obtain the additionalfunds needed to purchase all of the shares properly tendered.  If following such extension additional fundsare not available to enable the Company to purchase all properly tenderedshares, the Company will terminate the offer and return all sharestendered.  The Company currently doesnot have any alternative financing arrangements or financing plans in the eventavailable cash is insufficient to purchase all tendered shares

 

**Contractual Obligations and Commitments**

 

The following summarizes theCompany’s significant obligations and commitments to make future contractualpayments as of December 31, 2002. The Company has guaranteed the debt of otherparties as discussed in Note 11 to the consolidated financial statements.

 

Borrowings under the Company’smortgage notes were $151,423,000 at December 31, 2002, which includes theprevious revolving line of credit that has been converted to a mortgage note.  Annual maturities of the mortgage notes asof December 31, 2002, are as follows:

 

| **(In Thousands)** |   |    |    |
|--------------------|--------|---------|---------|
|               |   |    |    |
| 2003               |   | $       | 3,680   |   |
| 2004               |   | 4,731   |    |
| 2005               |   | 8,295   |    |
| 2006               |   | 4,553   |    |
| 2007               |   | 28,961  |    |
| Thereafter         |   | 101,204 |    |
|               |   | $       | 151,424 |   |

 

For additional information, seeNote 13 to consolidated financial statements.

 

The capital lease obligationassociated with the transmission system is due in September 2003.  The Company has received various proposalsto either refinance the debt associated with the transmission system or sellits transmission assets.  For additionalinformation concerning the capital lease, see Note 14 to the consolidatedfinancial statements.

 

Required principal payments forthe note payable and other capital leases as of December 31, 2002, were $12,920,000,of which $12,612,000 is due in 2003 with the remaining balance of $308,000 duein various installments through 2007. For additional information concerning note payable and other capitalleases, see Notes 14 and 15 to the consolidated financial statements.

 

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For information concerningcommitments and contingencies, see Note 26 to consolidated financialstatements.

 

For information related topower requirements and contracts, see “Power Requirements.”

 

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**Cash Flow Data**

 

During the nine months endedDecember 31, 2001, cash provided from operations was $11,257,000. Thisrepresents an increase of $5,525,000 over the corresponding period in 2000. Significantitems accounting for the increase include:

 

•                  an increase in net income of $8,346,000 as explainedin the section “Results of Operations;”

•                  increase due to write off of investments in 2000;and

•                  offset by an increase in the change of thepurchase power cost subject to refund of $5,216,000.

 

During the nine months endedDecember 31, 2001, cash out flows attributable to investing activities was$2,233,000 as compared with $23,867,000 in 2000. The decrease in cash flow,$21,634,000, is attributable to:

 

•                  areduction in capital investments in plant additions of $4,018,000;

•                  reduction in nonutility assets of $849,000;

•                  note receivables issued of $14,667,000 in 2000;and

•                  offsetby payments received on a note receivable in the amount of $2,100,000.

 

During the nine months endedDecember 31, 2001, cash used in financing activities was $9,262,000 as comparedto $17,423,000 provided by financing activities during the corresponding periodin 2000. This decrease of $26,685,000 was primarily due to:

 

•                  proceeds from issuance of mortgage notes of$14,917,000 in 2000;

•                  issuance of note payable in 2000 of $15,000,000;

•                  lower CFC loan payments of $5,269,000 in 2001 ascompared to 2000; and

•                  rescission offer discounted cash payments of$1,118,000 in 2001.

 

**New Accounting Standards**

 

On August 15, 2001, the FASBissued SFAS No. 143, “Asset Retirement Obligations.” SFAS No. 143addresses the financial accounting and reporting for obligations associatedwith the retirement of tangible long-lived assets and the associated assetretirement costs. SFAS No. 143 is required for adoption for fiscal yearsbeginning after June 14, 2002. The Company anticipates that the adoptionof SFAS No. 143 will not have a significant effect on its results ofoperations or financial position.

 

In July 2002, the FASBissued SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities.” SFAS No. 146 requires that a liability for costsassociated with an exit or disposal activity be recognized and measuredinitially at fair value only when the liability is incurred. SFAS No. 146is effective for exit or disposal activities that are initiated afterDecember 31, 2002. The Company anticipates that the adoption of SFASNo. 146 will not have a significant effect on its results of operations orfinancial position.

 

In November 2002, the FASBissued FASB Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, including Indirect Guarantees of Indebtedness ofOthers” (“FIN 45”). FIN 45 requires a guarantor to recognize a liability, atthe inception of the guarantee, for the fair value of obligations it hasundertaken in issuing the guarantee and also include more detailed disclosureswith respect to guarantees. FIN 45 is effective for guarantees issued ormodified after December 31, 2002 and requires the additional disclosuresfor interim or annual periods ended after December 15, 2002. The Companydoes not expect that the provisions of FIN 45 will have a material impact onits results of operations or financial position.

 

In January 2003, the FASBissued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities— an interpretation of ARB No. 51” (“FIN 46”). FIN 46 requires that if anentity has a controlling financial interest in a variable interest entity, theassets, liabilities and results of activities of the variable interest entityshould be included in the consolidated financial statements of the entity. FIN46 requires that its provisions are effective immediately for all arrangementsentered into after January 31, 2003. For those arrangements entered intoprior to January 31, 2003, the FIN 

 

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46 provisions are required to be adopted atthe beginning of the first interim or annual period beginning afterJune 15, 2003. The Company does not expect that the provisions of FIN 46will have a material impact on the Company’s results of operations or financialposition.

 

In December, 2002, the FASBissued SFAS No. 148, “Accounting for Stock-Based Compensation,” Transition andDisclosure, an amendment of FASB Statement No. 123 (SFAS No. 148).  SFAS No. 148 amends FASB Statement No. 123,“Accounting for Stock-Based Compensation” (SFAS No. 123), to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 to require prominent disclosures inboth annual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults.  The Company has adopted theintrinsic method of accounting for its stock-based compensation.  The Company does not believe that theprovisions of SFAS No. 148 will have a material impact on the Company’s resultsof operations or financial position.

 

**ITEM7A.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Market risk represents the riskof changes in the value of a financial instrument, derivative ornon-derivative, caused by fluctuations in interest rates, foreign currencyexchange rates, prices of commodities and equity price risks.

 

**Commodity Price Risk**

 

All purchases of electricityare pursuant to long-term wholesale electric power contracts based on a fixedprice for kWh usage, transportation and auxiliary services and a variablecharge for fuel cost, which is generally natural gas. All of the actual costsassociated with the purchase of electricity are able to be recovered frombillings to our customers, which mitigates most of the risk of variations ingas costs.

 

In the first quarter of 2001,the Company entered into two derivative transactions to fix a portion of thenatural gas component of the related power costs over the next twelve months tominimize the fluctuations in their customer’s power bills. These transactionsfixed the price on approximately 35,000 to 260,000 MMBtus of natural gas atfixed prices ranging from $3.79 to $5.31 an MMBtu. All payments made orreceived in connection with these transactions were collected or rebated to thecustomers through the power cost recovery component of the customers’ powerbills.   The last derivative contractexpired in May 2002.  The Company usesthis type of instrument to manage costs for its customers.

 

**Credit Risk**

 

The Company’s concentrations ofcredit risk consist primarily of cash, trade accounts receivable, salesconcentrations with certain customers and a note receivable from a third party.

 

Credit risk with financialinstitutions is considered minimal because of the number and various physicallocations of different financial institutions utilized.  The Company has utilized repurchaseagreements, and may consider using that vehicle again in the future to maximizereturn and minimize credit risk.

 

The Company conducts creditevaluations of new customers and assesses the need for a deposit by thatcustomer.  The deposit amount isnormally set as 1/6 of an annual customer billing, with such amounts being refundedor credited to the customer after one year if they have paid timely at least 10of the last 12 billings.  No customeraccounted for 10% or more of operating revenues of the Company.

 

In connection with aninvestment in United Fuel and Energy Corporation, the Company has a notereceivable from United Fuel with a current balance of $13,667,000, with a finalballoon payment due in July 2003.  Theinterest rate is variable, and is tied to the interest rate on the Company’snote payable to a bank.

 

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**Interest Rate Risk**

 

We are subject to market riskassociated with interest rates on our CFC long-term indebtedness.  The Company’s mortgage debt with CFC allowsfor a change from variable rate to fixed rate with no additional fees.  In order to take advantage of the interestrate environment in late 2002 as well as employ an interest rate managementstrategy, the Company fixed the interest rates on $11,525,000 of its debt at3.35% for a period of one year, on $70,519,000 at 4.20% for a period of twoyears and on $35,189,000 at 4.70% for a period of three years.  At December 31, 2002, there was $28,000,000at an average variable rate of 3.9% and $6,187,000 at a fixed rate of6.5%.  Pursuant to the terms of the mortgagenotes, our variable debt with CFC is CFC prime rate plus 1%.  A 1% increase in interest rates results inan approximate increase of $280,000 in interest expense.

 

**Company Purchase Commitment**

 

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 terms of the conversionplan, the Company made a commitment to offer to purchase those shares, heldcontinuously by the original owners of record until the first anniversary ofthe distribution of the shares at a price of $10 per share if the Company hadsufficient cash available to purchase all shares tendered.  Although the original purchase commitmentwas only to original holders, the Company, in its desire to be inclusive ratherthan exclusive, has extended the offer to all shareholders.  The offering period began February 5, 2003,and will end April 30, 2003.

 

Theeffect of the common stock purchase commitment is unknown because it is basedon the number of eligible shareholders who accept the offer.  If all shareholders tendered their shares,the maximum amount of funds required would be $13,023,055.  The Company currently has cash availablefrom its operations of $550,000 with which to purchase tendered shares.  While additional cash from operations maybecome available, the Company does not believe substantially more than 55,000shares will be tendered.  If the numberof shares tendered exceeds the Company’s cash available to purchase all sharestendered at that time, the Company may extend the offer once in order to try toobtain the additional funds needed to purchase all of the shares properlytendered.  If following such extensionadditional funds are not available to enable the Company to purchase allproperly tendered shares, the Company will terminate the offer and return allshares tendered.  The Company currentlydoes not have any alternative financing arrangements or financing plans in theevent available cash is insufficient to purchase all tendered shares.

 

**ITEM8.  FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The Consolidated FinancialStatements are set forth on pages F-1 through F-32 of this Form 10-K.

 

**ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Effective July 26, 2002, theAudit Committee dismissed Arthur Andersen LLP (“Arthur Andersen”) as theCompany’s independent accountants and engaged KPMG LLP (“KPMG”) to serve as theCompany’s independent accountants for the year ended December 31, 2002, asreported on Form 8-K dated July 26, 2002.

 

The reports of ArthurAndersen on the financial statements of the Company’s predecessor, Cap RockElectric Cooperative, Inc. for the year and period ended March 31, 2001, andDecember 31, 2001, did not contain any adverse opinion or disclaimer ofopinion, nor were they qualified or modified as to uncertainty, audit scope oraccounting principles.

 

During the Cooperative’syear ended March 31, 2001, and period ended December 31, 2001, as well as thesubsequent interim period through July 26, 2002, for both the Company and theCooperative, there were no disagreements with Arthur Andersen on any matter ofaccounting principles or practices, financial statement disclosure, or auditingscope or procedures, which agreements, if not resolved to the satisfaction ofArthur Andersen, would have caused Arthur Andersen to make reference to thesubject matter of the disagreements in connection with its reports.

 

The Company requested thatArthur Andersen furnish a letter addressed to the SEC stating whether or not itagrees with the above statements.  TheCompany understands that it will be unable to obtain that letter.

 

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During the Cooperative’syear ended March 31, 2001, and its period ended December 31, 2001, and theCompany’s subsequent interim period through July 26, 2002, KPMG has not beenengaged as an independent accountant to audit either the Cooperative’s or theCompany’s financial statements or the financial statements of any of theirconsolidated subsidiaries, nor has KPMG been consulted regarding theapplication of the Company’s accounting principles to a specified transaction,either completed or proposed, or the type of audit opinion that might berendered on the Company’s financial statements, or any other matters orreportable events listed in Items 304(a)(2)(i) and (ii) of Regulation S-K.

 

**PART III**

 

**ITEM10.  DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

**Directors And Executive Officers**

 

The information required by this itemconcerning the Company’s executive officers is included in Part I, Item 4, ofthis Form 10-K.

 

The following table sets forthcertain information regarding the directors of the Company as of December 31,2002:

 
| **NAME**                       |   | **AGE** |   | **POSITION**                                                     |   |
|--------------------------------|--------|---------|--------|------------------------------------------------------------------|--------|
| David W. Pruitt                |   | 56      |   | Co-Chairman of the Board,  President and Chief Executive Officer |   |
|                           |   |    |   |                                                             |   |
| Michael D. Schaffner (1)       |   | 55      |   | Director                                                         |   |
|                           |   |    |   |                                                             |   |
| Russell E. Jones (1)           |   | 57      |   | Co-Chairman of the Board                                         |   |
|                           |   |    |   |                                                             |   |
| Sammie D. Buchanan (1) (2)     |   | 59      |   | Director                                                         |   |
|                           |   |    |   |                                                             |   |
| Jerry R. Hoelscher (1) (2) (3) |   | 53      |   | Director                                                         |   |
|                           |   |    |   |                                                             |   |
| Floyd L. Ritchey (1) (2)       |   | 64      |   | Director                                                         |   |
|                           |   |    |   |                                                             |   |
| Newell W. Tate (1)             |   | 73      |   | Director                                                         |   |

 

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(1) Audit Committee

(2) Compensation Committee

(3) Mr. Hoelscher resigned fromthe Board in January 2003 for personal reasons.

 

Set forth below is adescription of the background of each of the directors of the Company:

 

*•**                                         **David W. Pruitt* has served as a director of theCompany since its inception and was elected as a Co-Chairman of the Board inFebruary 2001. He currently serves as the President and Chief Executive Officerof the Company. Mr. Pruitt also served as the President and Chief ExecutiveOfficer of the Cooperative from August 1987 until inception of the Company. Mr.Pruitt’s term as director expires in 2004.

 

*•**                                         **Michael D*. *Schaffner*has served as a director of the Company since October 1999. He alsoserved as a director of the Cooperative from October 1999, and prior to that heserved as a director of McCulloch Electric Cooperative, Inc., a cooperativethat consolidated into the Cooperative. Mr. Schaffner is engaged inpublic accounting in Brady, Texas, and has owned his own accounting firm formore than the past five years. Mr. Schaffner’s term expires in 2005.

 

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*•**                                         **Russell E*. *“Rusty”Jones*has been a director of the Company since its inception andcurrently serves as Co-Chairman of the Board of the Company. Mr. Jones servedas a member of the Board of Directors of the Cooperative since September 1979and until inception of the Company. Mr. Jones has been a farmer and rancher forhis entire business career, including owning and operating his own agriculturalbusinesses for more than the past five years. Mr. Jones’ term expires in 2004.

 

*•**                                         **Sammie D*.*Buchanan*has been a director of the Company since its inception. Heserved as a director of the Cooperative from September 1975 until inception ofthe Company. Mr. Buchanan has been a farmer and rancher for his entire businesscareer, including owning and operating his own agricultural businesses for morethan the past five years. Mr. Buchanan’s term expires in 2003.

 

*•**                                         **Jerry R*.*Hoelscher*hadbeen a director of the Company since its inception and served as a director ofthe Cooperative from February 1995 until inception of the Company.  Mr. Hoelscher has been a farmer and rancherfor his entire business career, including owning and operating his ownagricultural businesses for more than the past five years. Mr. Hoelscherresigned from the Board in January 2003. His term was set to expire in 2003.

 

*•**                                         **Floyd L. Ritchey* has been a director of the Companysince its inception. He served as a director of the Cooperative from February1998 until inception of the Company, and prior to that he served as a directorof Lone Wolf Electric Cooperative, Inc., a cooperative that consolidated intothe Cooperative. Mr. Ritchey has been a farmer and rancher for his entirebusiness career, including owning and operating his own agricultural businessesfor more than the past five years. Mr. Ritchey’s term expires in 2003.

 

*•**                                         **Newell W. Tate*has been a director of the Companysince its inception. He served as a director of the Cooperative from September1986 until inception of the Company. Mr. Tate has been a farmer for his entirebusiness career, including owning and operating his own agricultural businessesfor more than the past five years. Mr. Tate’s term expires in 2005.

 

**Section 16 (a) Beneficial Ownership ReportingCompliance**

 

Section 16 (a) of theSecurities Exchange Act of 1934, as amended, requires the Company’s directorsand executive officers and persons who own more than 10% of a registered classof the Company’s equity securities (collectively, the “Reporting Persons”) tofile reports of ownership on Form 3 and changes in ownership on Form 4 or Form5 with the Securities and Exchange Commission. The Reporting Persons are alsorequired to furnish the Company with copies of all Section 16 (a) reports theyfile.

 

Celia A. Zinn filed Form 3,“Initial Statement of Beneficial Ownership of Securities” on March 24, 2003,pursuant to her election as Vice President on December 2, 2002. No transactionsoccurred which were required to be reported prior to March 24, 2003.

 

Based solely upon a review ofthe copies of these reports furnished to us, all persons subject to thereporting requirements of Section 16 (a), with the aforementioned exception,filed the required reports on a timely basis for the year ended December 31,2002.

 

**ITEM11.  EXECUTIVE COMPENSATION**

 

**Compensation of Directors**

 

Each of our directors, withthe exception of David W. Pruitt, is considered an outside director becausethey are not salaried employees of the Company. In 2002, the standardarrangements for compensation of Board members was as follows:

 

•                  committee meeting attendance and telephonemeeting fees were changed to $500 and $250, respectively;

•                  stock awards of $10,000 annually, with eachdirector having the option to choose all stock, or half stock and half cash;

 

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•                  outside directors who resign from the Board,become advisory directors and were former directors of the Cooperative willreceive the same benefits as a director for up to six years. If the advisorydirector should resign during the six year period, he will be entitled toreceive stock options for 35,000 shares at an exercise price based on marketprice;

•                  outside directors who resign from the Board,choose not to become an advisory director, but were former directors of theCooperative will receive stock options for 35,000 shares at an exercise pricebased on market price.

 

In addition, directorsparticipate in the Achievement Based Compensation Contract - Merger orAcquisition with Other Electric Utilities. See “Compensation Committee Report”for a discussion of that plan.

 

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**Compensation of Named Executive Officers**

 

The following table describesthe compensation paid to our President and Chief Executive Officer and each ofthe other executive officers with total salary and bonus in excess of $100,000for services rendered during the year ended December 31, 2002, nine monthsended December 31, 2001, and the year ended March 31, 2001.

 
|                                                                             |   |                                   |   | **Annual Compensation** |    | **All Other Compensation (b)** |   |
|----------------------------------------------------------------------------------|--------|----------------------------------------|--------|-------------------------|---------|--------------------------------|--------|
|                                                                             |   |                                   |   |                    |    |                           |   | **Other Annual  Compensation (a)** |   |   |
| **Name and  Position**                                                           |   | **Year**                               |   | **Salary**              |    | **Bonus**                      |   |   |   |
| David W. Pruitt                                                                  |   | Twelve Months Ended December 31,  2002 |   | $                       | 214,995 |                           | $      | 39,001 |   | $ | 100,795 |   | $ | 118,868 |   |
| Co-Chairman of the Board,                                                        |   | Nine Months Ended December 31, 2001    |   | 155,734                 |    | 82,948                         |   | 18,046 |   | 19,085 |   |
| President and Chief Executive  Officer                                           |   | Twelve Months Ended March 31, 2001     |   | 181,009                 |    | 116,383                        |   | 16,497 |   | 49,035 |   |
|                                                                             |   |                                   |   |                    |    |                           |   |   |   |   |   |
| Ulen A. North, Jr.                                                               |   | Twelve Months Ended December 31,  2002 |   | 110,879                 |    | $                              | 39,001 |   | 41,880 |   | 66,345 |   |
| Executive Vice President                                                         |   | Nine Months Ended December 31, 2001    |   | 89,200                  |    | 32,845                         |   | 8,823 |   | 12,707 |   |
|                                                                             |   | Twelve Months Ended March 31, 2001     |   | 103,874                 |    | 32,704                         |   | 8,609 |   | 41,904 |   |
|                                                                             |   |                                   |   |                    |    |                           |   |   |   |   |   |
| Sammy C. Prough                                                                  |   | Twelve Months Ended December 31,  2002 |   | 88,259                  |    | —                         |   | 32,306 |   | 33,567 |   |
| Vice President and Chief                                                         |   | Nine Months Ended December 31, 2001    |   | 63,931                  |    | 25,000                         |   | 7,618 |   | 9,820 |   |
| Operating Officer                                                                |   | Twelve Months Ended March 31, 2001     |   | 82,688                  |    | 19,000                         |   | 6,770 |   | 13,620 |   |
|                                                                             |   |                                   |   |                    |    |                           |   |   |   |   |   |
| Lee D. Atkins (c)  Senior Vice President,  Chief Financial Officer and Treasurer |   | Twelve Months Ended December 31,  2002 |   | 182,000                 |    | —                         |   | 2,264 |   | 17,484 |   |
|                                                                             |   |                                   |   |                    |    |                           |   |   |   |   |   |
| Ronald W. Lyon (d)  Vice President, General Counsel and Secretary                |   | Twelve Months Ended December 31,  2002 |   | —                  |    | —                         |   | — |   | 184,000 | (e) |
|                                                                             |   |                                   |   |                    |    |                           |   |   |   |   |   |
| Celia A. Zinn  Vice President, Assistant Secretary/ Treasurer and Controller     |   | Twelve Months Ended December 31,  2002 |   | 104,000                 |    | —                         |   | 264 |   | 15,206 |   |
|                                                                                  |        |                                        |        |                         |         |                                |        |  |  |  |  |  |  |  |  |

 

In October 2001, the Companychanged its year end from March 31 to December 31. Therefore, compensation datais presented for the year ended December 31, 2002, the nine-month transitionperiod ended December 31, 2001, and the fiscal year ended March 31, 2001.

 

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(a)                                  The Board of Directors allowed each of theindividuals to defer certain bonus amounts for 2001. Pursuant to the Stock forCompensation Plan of the Company, the Compensation Committee allowed theindividuals to convert a portion of the previously deferred amounts into commonstock at a discount, with such discount being a nonrecurring item. The value ofthe discount on the stock was $82,948, $32,845, $25,000, and $2,000 for Messrs.Pruitt, North, Prough and Atkins, respectively. Although the amounts have beenaccrued, there have been no distributions or payments made to date.

(b)                                 Amounts for the year ended December 31, 2002,include: $18,752, $13,860, $5,250, $11,032 and $3,000 for Messrs. Pruitt,North, Atkins, Prough and Ms. Zinn, respectively, for Company contributions tothe 401(k) plan; $5,113, $3,485, $2,234, $2,535 and $2,206 for premiums paid onterm life insurance for Messrs. Pruitt, North, Atkins, Prough and Ms. Zinn,respectively; $12,000 contribution to a deferred compensation accountfor Mr. Lyon; and $95,003, $49,001, $20,000, $10,000, $10,000 and$10,000 representing the value of shares received under our Stock forCompensation Plan in lieu of cash compensation by Messrs. Pruitt, North,Prough, Atkins, Lyon and Ms. Zinn, respectively. The individuals deferredreceipt of the shares pursuant to the plan. Although the amounts have beenaccrued, there have been no distributions or payments made to date.

(c)                                  Mr. Atkins became an executive officer inSeptember 2001.

(d)                                 Mr. Lyon became an executive officer inOctober 2001.

 

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(e)                                  Mr.Lyon’s employment contract with the Company as retained general counsel hasterms pursuant to which he provides for his own administrative support and maintenanceof his separate office facilities. See “Certain Relationships and RelatedTransactions” for a description of the arrangement.

 

**Compensation Committee Report**

 

The Compensation Committeeof the Board of Directors (the “Committee”), which is composed of threenon-employee directors, administers the executive compensation programs of theCompany. The Committee reviews and approves all issues pertaining to executivecompensation. The objective of the Company’s compensation programs is toprovide compensation that enables the Company to attract, motivate and retaintalented and dedicated executives, foster a team orientation toward theachievement of business objectives, and directly link the success of ourexecutives with that of our shareholders. The Committee held four meetings during 2002.

 

The Company extendsparticipation in its incentive programs to certain key employees, in additionto executive officers, based on their potential to contribute to increasingshareholder value. The Company intends to expand incentive programs to allregular employees of the Company in the future.

 

In structuring the Company’scompensation plans, the Committee takes into consideration Section 162(m) ofthe Internal Revenue Code (which disallows the deduction of compensation inexcess of $1 million except for certain payments based upon performance goals)and other factors the Committee deems appropriate. As a result, if compensationin excess of $1 million is paid under the Company’s compensation plans, aportion may not be deductible under Section 162(m).

 

**•****                    ****Base Salary Compensation**

 

A base salary range isestablished for each executive position to reflect the potential contributionof each position to the achievement of the Company’s business objectives and tobe competitive with the base salaries paid for comparable positions in thenational market by similar companies. The Committee utilized industryinformation for compensation purposes. In addition, the Committee considersinformation about other companies with which the Committee believes the Companycompetes for executives, but which are not part of such industry information.

 

Within the established basesalary ranges, actual base salary is determined by the Company’s performance inrelation to attainment of specific goals, and a subjective assessment of eachexecutive’s achievement of individual objectives and managerial effectiveness.The Committee annually reviews the performance of the Co-Chairman of the Board,President and Chief Executive Officer and receives reports on other executiveofficers whose performances are reviewed by the Chief Executive Officer. TheCommittee, after consideration of the Company’s financial performance and suchother subjective factors as the Committee deems appropriate for the periodbeing reviewed, establishes the base compensation of such officers.

 

In reviewing the annualachievement of each executive and setting the new base annual salary levels for2002, the Committee considered each individual’s contribution toward meetingthe board-approved budgeted financial plan for the previous year, customersatisfaction, compliance with the Company’s capital financial plan, theindividual’s management effectiveness and the individual’s base compensationcompared to the national market.

 

**•****                    ****Annual Incentive Compensation**

 

All executive officers areeligible for annual incentive compensation.

 

The primary form of annualincentive compensation is the Company’s Annual Incentive Plan for employeesselected by the Committee, including the executive officers, which have anopportunity to directly and substantially contribute to the Company’sachievement of short-term objectives. Annual incentives are structured so thatpotential compensation is based upon evaluation of the CEO by the Board of Directorsand the accomplishment of goals set during the year and the CEO’s evaluation ofselected employees which include the named executive officers.

 

Changes in annual incentivecompensation to the executive officers in 2002 compared to 2001 resulted froman

 

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individual’s relative attainment of his or her goals, the achievementof certain performance standards for business units over which an executiveofficer had responsibility, and the Company achieving certain financial,performance and other goals.

 

For 2002, Mr. Pruitt waseligible for an annual short-term incentive target of up to 30% of base salary.Other participants were eligible for annual short-term incentive payments asdetermined by the CEO. The annual incentive for selected employees andexecutive officers was tied to the attainment of individual goals andmanagement skills. The balance was based upon the Company’s achievement ofgoals that are established annually. Mr. Pruitt’s annual incentive compensationwas determined to be $56,002. The annual incentive compensation for the namedexecutive officers was determined to be $10,000 for Mr. North, $20,000 for Mr.Prough, $10,000 for Mr. Atkins, $10,000 for Mr. Lyon, and $10,000 for Ms. Zinn.All executive officers, including the CEO, have elected to receive the annualincentive compensation in the form of common stock of the Company. Although theamounts have been accrued, there have been no distributions or payments in theform of common stock to date.

 

**•****                    ****Achievement Based Compensation**

 

In October 1992, theCooperative entered into an Achievement Based Contract-Southwestern PublicService Company (“ABC-SPS Contract”) with David W. Pruitt, Ulen North and twoformer employees. In accordance with the terms of the ABC-SPS Contract, thecompensation distributed to the individuals equals 2% of the annual netpurchased power cost savings derived from the SPS purchased power contractcompared to the prior Texas Utilities purchased power contract and the powersupply agreements for the Hunt-Collin Division. The compensation is computed asof the end of each calendar year based on an assessment of the estimatedsavings and is approved by the Compensation Committee. The ABC-SPS Contract,which has been assumed by the Company, expires in October 2003. For the yearended March 31, 2001, $124,000 was paid pursuant to the Contract. For the yearended December 31, 2002, and the nine months ended December 31, 2001,compensation attributable to the contract was approximately $156,000 and$48,000, which amounts have not been paid, but are shown as a liability on thebalance sheet.

 

In June 1999, theCooperative entered into an Achievement Based Compensation Contract-Merger orAcquisition With Other Electric Utilities (“ABC-Merger Contract”) with thenamed executives, certain other officers, and its directors and advisorydirectors, a total of 16 individuals. The ABC-Merger Contract was amended in2000. In accordance with the terms of the ABC-Merger Contract, the participantsreceive compensation equal to 1.5% of the total assets added to the Cooperativeor the Company by merger or acquisition since 1990. Total assets added meansonly those mergers or acquisitions of electric or telephone cooperatives ormunicipal electric systems that require only the assumption of debt and equity.Amounts paid under the ABC-Merger Contract are allocated 60% to participatingexecutive officers, 10% is allocated to the general counsel and 30% isallocated to directors and advisory directors. The ABC-Merger Contract, whichhas been assumed by the Company, expires in August 2010. No amounts have beenpaid or accrued under the ABC-Merger Contract for the year ended December 31,2002, nine months ended December 31, 2001, or the year ended March 31, 2001.

 

In August 2001, theCooperative entered into an Achievement Based Compensation Contract-PowerTransmission Contract (“ABC-Power Transmission Contract”) involving itsexecutive officers, including the named executives, directors and a formerdirector. The Company has assumed the ABC-Power Transmission Contract. Inaccordance with the terms of the ABC-Power Transmission Contract, theparticipants will receive compensation equal to 1.0% of the net profit or netcapital acquired by the Cooperative or Company in connection with the sale orleaseback of the transmission system if payment is taken in cash or 2.0% ifpayment is taken in stock of the Company. Payment will be deferred until theearlier of 2003 or new equity is raised by the Company in the amount of $5million or more. Amounts paid under the ABC-Power Transmission Contract areallocated 60% to the executive officers and the remaining 40% is allocatedequally to each of the directors and the former director. No amounts have beenpaid or accrued under the Power Transmission Contract.

 

**•****                    ****Stock Based Compensation**

 

Stock incentive compensationis offered to employees who are in positions that can affect the Company’slong-term success through the formation and execution of its businessstrategies. Stock incentive compensation is made under the Company’s StockIncentive Plan (the “SIP”). The SIP also allows grants to all full-time regularemployees of the

 

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Company selected by theCommittee. The SIP has been established to advance the interests of the Companyand its shareholders by providing a means to attract, retain and motivateemployees, directors and consultants upon whose judgment, initiative and effortthe Company’s continued success, growth and development is dependent. Thepurposes of stock incentive compensation are to: (1) focus key employees’efforts on performance which will increase the value of the Company to itsshareholders; (2) align the interests of management with those of the Company’sshareholders; (3) provide a competitive long term incentive opportunity; (4)provide a retention incentive for key employees; and (5) provide a method toreduce the Company’s short term cash needs.

 

Under the SIP, awards areprovided to such participants, and in such amounts, as the Committee deemsappropriate. The number and form of awards vary on the basis of position andpay level. The level of total compensation for similar positions in companiesconsidered comparable by the Committee is used as a reference in establishingthe level of awards.

 

For the year ended December31, 2002, directors received an aggregate of 3,000 shares under the SIPpursuant to the standard arrangement for compensation of directors.

 

In June 2002, the Committeeadopted a Stock for Compensation Plan that allows the Company’s officers,including the named executive officers, directors and other key employeesselected by the Compensation Committee to elect to receive cash compensation inthe form of common stock. The Board believes that the Stock for CompensationPlan will promote the interests of the Company and its shareholders byassisting the Company in attracting, retaining and stimulating the performanceof employees and directors, and by aligning their interests through ownershipof common stock with interests of shareholders, and provide a method for theCompany to reduce short term cash requirements. As part of its review of 2002compensation, the Compensation Committee allowed certain officers and directorsof the Company, including the individuals named in the compensation table, toconvert a portion of the 2001 cash bonus previously deferred by the individualsinto shares of common stock at a discount on the date of valuation. Thediscounts are reflected in the compensation table above.

 

In the event of a change incontrol, such stock based incentives or compensation may accelerate and vest,and restrictions or performance criteria lapse. No shares have been grantedunder these plans.

 

**•****                    ****Chief Executive Officer**

 

Mr. Pruitt’s base salary andhis annual short-term incentive compensation are established annually. Inrecommending the base salary to be effective in 2002, while not utilizing anyspecific performance formula and without ranking the relative importance of eachfactor, the Committee took into account relevant salary information in thenational market and the Committee’s subjective evaluation of Mr. Pruitt’soverall management effectiveness in his position as Co-Chairman of the Board,President and Chief Executive Officer of the Company and his achievement ofindividual goals. Factors considered included his continuing leadership of theCompany and his contribution to strategic direction, management of change in anincreasingly competitive environment, management of operations, and the overallproductivity of the Company. Mr. Pruitt’s base salary was $215,000 in 2002. Inaddition, pursuant to the terms of the Stock for Compensation Plan, theCompensation Committee allowed Mr. Pruitt to convert previously deferred cashcompensation into shares of common stock at a discount. The discount isreflected in the compensation table above.

 

Based upon the abovefactors, Mr. Pruitt’s 2002 short term incentive compensation was set at$56,002. Mr. Pruitt will also receive $78,002 under the Achievement BasedContracts for 2002. Mr. Pruitt elected to receive shares of common stock underthe Company’s Stock for Compensation Plan in lieu of these cash bonuses, whichhave not been distributed or paid to date.

 
|   | The  Compensation Committee   |
|--------|-------------------------------|
|   |                          |
|   | Sammie  D. Buchanan, Chairman |
|   | Floyd  L. Ritchey             |

 

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**Executive Officer Employment Contracts**

 

The Company has entered intoemployment contracts, which contain change in control provisions, with theexecutive officers. The agreements are intended to insure the officers’continued service and dedication to the Company and to ensure their objectivityin considering, on the Company’s behalf, any transaction that would result in achange in control of us. The material terms of those contracts are as follow:

 

David W. Pruitt’s contractcommenced in August 1992 and is for an initial term of 10 years. Unless awritten notice to terminate the contract at the end of the initial term isgiven at least 360 days prior to the eighth anniversary of the initial term,the contract term is automatically extended for a three-year term from theeighth anniversary date. Thereafter, unless a written notice to terminate thecontract is given 90 days prior to any subsequent anniversary date, thecontract automatically extends for an additional three-year term. The contractcan be terminated earlier for good cause, as defined in the contract, whichincludes dishonesty and neglect by Mr. Pruitt of his job duties. There is also aprovision in Mr. Pruitt’s contract that if his job responsibility and authorityare limited, changed or eliminated or if he is required to move from theMidland, Texas, area, he will be paid for the remainder of the term of hiscontract.  Mr. Pruitt’s contract hasbeen extended to August 2005. If there is a change in control and the contractterminates, Mr. Pruitt will receive an amount equal to six times the sum of hisannual base salary and the greater of the highest bonus awarded to him in aprior year or 50% of his annual base salary. The contract also has provisionsfor healthcare coverage similar to that of a retiree, reimbursement of any taxor tax payments Mr. Pruitt may be required to make for any excise tax imposedunder Section 4999 of the Internal Revenue Code, and reimbursement of any taxesresulting from the excise tax reimbursement.

 

Other officers, includingthe named executives, have contracts with initial terms of one to two years.Unless a written notice to terminate is given prior to an anniversary date ofthe contract, they automatically renew for a one to two year term. Thecontracts can be terminated earlier if the Chief Executive Officer determinesthat the officer is not properly performing the duties of his or her job or forcause, as defined in the contract, which includes dishonesty and neglect by theofficer of his job duties. If the contract is terminated for any other reason,other than a change of control, the officer will receive an amount equal to hisor her current salary and benefits for a period of one to two years. If thereis a change of control and the contract terminates, the officer will receive anamount equal to six times the sum of his or her annual base salary and thegreater of the highest bonus awarded to him or her in a prior year or 50% ofhis or her annual base salary. The contracts also have provisions forhealthcare coverage similar to that of a retiree, reimbursement of any tax ortax payments the officer may be required to make for any excise tax imposed underSection 4999 of the Internal Revenue Code, and reimbursement of any taxesresulting from the excise tax reimbursement.

 

In the event of atermination by the Company other than for cause, stock based incentives orcompensation may accelerate and vest, and restrictions or performance criteriamay lapse.

 

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**Performance Graph**

 

The following graph shows aone year comparison, prepared in accordance with the rules of the Securitiesand Exchange Commission, of cumulative total shareholders’ returns for ourcommon stock, the S&P 500 Index and the S&P Utilities Index.  The Company’s stock began trading on theAmerican Stock Exchange on March 14, 2002, therefore, the graph represents databeginning in March 2002 for Cap Rock Energy Corporation with a complete 12months data being provided for S&P 500 and S&P Utilities.

 

****

 

**ITEM12.  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

Other than as set forth inthe following table, we know of no other beneficial owner of more than fivepercent of our outstanding common stock. The information provided is as ofMarch 28, 2003.

 
| **Name and  Address of  Beneficial Owner (1)**                                           |   | **Amount and Nature  of Beneficial Ownership** |   | **Percent of Class** |   |
|------------------------------------------------------------------------------------------|--------|------------------------------------------------|--------|----------------------|--------|
|                                                                                     |   |                                           |   |                 |   |
| Cap Rock Energy  Corporation  Shareholders’ Trust  115 S. Travis  Sherman, TX 75090 |   | 341,882  shares of Common Stock                |   | 26.3%                |   |

 

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(1) As reported in Schedule13D filed with the Securities and Exchange Commission on October 3, 2002.Trustees of the Trust are Alfred J. Schwartz and Robert G. Holman, who haveshared power to vote and dispose of the shares, pursuant to certain provisionsin the Trust document.  See also Item13. Certain Relationships and Related Transactions.

 

The following table setsforth certain information regarding the beneficial ownership of our commonstock as of March 28, 2003, by each of our directors and named executiveofficers, and by all of our directors and executive officers as a group. Exceptas otherwise indicated below, each of the persons named in the table have solevoting and investment power with respect to the shares beneficially owned bysuch person as set forth opposite such person’s name:

 

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| **Name  of beneficial owner**                                        |   | **Amount  and Nature  of Beneficial Ownership (1)** |   | **Percent  of Class (2)** |     |
|----------------------------------------------------------------------|--------|-----------------------------------------------------|--------|---------------------------|----------|
|                                                                 |   |                                                |   |                      |     |
| Directors                                                            |   |                                                |   |                      |     |
| Sammie  D. Buchanan                                                  |   | 1,710                                               |   | —                    |     |
| Russell  E. Jones                                                    |   | 2,514                                               |   | —                    |     |
| Floyd  L. Ritchey                                                    |   | 1,434                                               |   | —                    |     |
| Michael  D. Schaffner                                                |   | 1,533                                               |   | —                    |     |
| Newell  W. Tate                                                      |   | 2,956                                               |   | —                    |     |
|                                                                 |   |                                                |   |                      | * * |
| Executive  Officers                                                  |   |                                                |   |                      |     |
| David  W. Pruitt                                                     |   | 31,788                                              | (3)    | 2.4                       | %        |
| Ulen  A. North, Jr.                                                  |   | 11,538                                              |   | —                    |     |
| Sammy  C. Prough                                                     |   | 7,100                                               | (3)    | —                    |     |
| Lee  D. Atkins                                                       |   | 1,200                                               |   | —                    |     |
| Ronald  W. Lyon                                                      |   | 1,010                                               |   | —                    |     |
| Celia  A. Zinn                                                       |   | 1,000                                               |   | —                    |     |
|                                                                 |   |                                                |   |                      |     |
| *All Directors and Executive  Officers as a group  (11 individuals)* |   | *63,783*                                            |   | 4.7                       | %(4)     |

 

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(1)                                  Includes restricted share units deferredunder the Company’s Stock for Compensation Plan and deferred director awardsunder the Stock Incentive Plan as follows: Buchanan, 1,351; Jones, 787;Ritchey, 1,351; Schaffner, 1,351; Tate, 1,351; Pruitt, 26,088; North, 11,468;Prough, 7,000; Atkins, 1,200; Lyon, 1,000 and Zinn, 1,000 respectively.

 

(2)                                  No director or executive officer owns any ofour equity securities other than our common stock. Percentages are omitted ifthe person owns less than one percent of the outstanding shares of common stockcalculated in accordance with the rules of the Securities and ExchangeCommission.

 

(3)                                  Includes 5,700 shares for Mr. Pruitt and 100shares for Mr. Prough purchased by those individuals in open markettransactions at market price.

 

(4)                                  Includes deferred shares referred to in item(1) above.

 

**ITEM13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

One of the Company’s executiveofficers, Ronald W. Lyon, has an employment contract as retained generalcounsel with the Company, but is not considered an employee under Federal laborlaws. Mr. Lyon is paid a monthly retainer fee of $13,500 which is meant tocover the cost of maintaining his office, including administrative support,rent and other overhead expenses, as well as any salary he may draw. Inaddition, the Company contributes $1,000 per month to a deferred compensationplan for Mr. Lyon. The Company also reimburses Mr. Lyon for directout-of-pocket expenses he may incur on the Company’s behalf, such as fortravel, meals and meeting fees.

 

As shown in Item 12. SecurityOwnership of Certain Beneficial Owners and Management, the Cap Rock EnergyCorporation Shareholders’ Trust holds more than 5% of the outstanding shares ofthe Company.  The Trust was establishedby the Company on behalf of former members of the Cooperative whose currentaddresses are unknown and would have received stock in connection with theconversion of the Cooperative into the Company. The shared authority of the twoTrustees of the Trust is to make distribution of stock to beneficial ownerswhen they have been located. Other powers are limited to those granted in theTrust document, the Share Option Agreement and the Funding Agreement.

 

The Trust provides that in thecase of a tender offer or other repurchase offer by the Company for shares ofthe capital stock of the Company, the Trustees may, in their sole discretionand acting jointly in the best interest of the beneficiaries of the Trust, sellall of the shares held in the Trust to the Company at the highest cash priceoffered under the

 

35

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tender offer or other repurchase offer. Ifthe tender offer by the Company has a premium of 25% or more, the Trusteesshall sell all of the shares at the highest cash price offered. In addition,the Trustees shall not vote the shares in favor of a sale or pledge of assetsof the Company, nor for any change in the capital structure or powers of theCompany or in connection with a merger or dissolution, unless previouslyapproved by the Company’s Board of Directors.

 

The Funding Agreement betweenthe Trust and the Company provides that the Trustees may request funds from theCompany to pay for compensation and expenses of the Trustees in connection withtheir duties and responsibilities as Trustees of the Trust. In the event theCompany fails to fulfill its obligations under the Funding Agreement, theTrustees may sell such shares as are necessary for the Trust to pay suchcompensation and expenses. The Company transferred less than $1,000 in 2002 tothe Trust to pay for the Trustees’ costs and expenses.

 

The Option Agreement grants theCompany the right to acquire all of the shares that would otherwise escheat tothe State of Texas as the average market price of the shares for 30 tradingdays before the Company exercises its option.

 

**ITEM14.  CONTROLS AND PROCEDURES**

 

Within the 90-day period priorto the date of this report, an evaluation was carried out, under the supervisionand with the participation of management, including our chief executive officerand chief financial officer, of the effectiveness of the design and operationof our disclosure controls and procedures pursuant to Rule 13a-15 of theSecurities Exchange Act of 1934. Based upon that evaluation, the chiefexecutive officer and chief financial officer concluded that our disclosurecontrols and procedures are effective, subject to the limitations below, toensure that information required to be disclosed by the Company in reports thatit files or submits under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

 

There have been no significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect internal controls, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

The Company, including its CEOand CFO, does not expect that the Company’s disclosure and internal controlsand procedures will prevent or detect all error and all fraud. A controlsystem, no matter how well conceived or operated, can provide only reasonably,not absolute, assurance that the objectives of a control system are met.

 

**PART IV**

 

**ITEM15.  EXHIBITS, FINANCIAL STATEMENTSCHEDULES AND REPORTS ON FORM 8K**

 

**Financial Statements**

 

For a list of the consolidatedfinancial statements filed as part of this Form 10-K, see the Index toConsolidated Financial Statements on page F-1.

 

**Financial Statement Schedule**

 

The following financialstatement schedules are included in Item 14: Schedule II - Valuation andQualifying Accounts for the year ended December 31, 2002, nine months endedDecember 31, 2001, and the year ended March 31, 2001.

 

**Reportson Form 8-K**

 

During the quarter ended December 31, 2002, theCompany filed Form 8-K:

 

Reportingon October 8, 2002, that theCompany had scheduled its annual meeting of shareholders for December 2, 2002,and its record date for voting at the annual meeting as October 17, 2002.

 

36

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Reporting on October 22, 2002, that theCompany received a letter on behalf of the Board of Directors of Lamar ElectricCooperative Association, which stated that they intended to terminate theCombination Agreement.

 

Reporting as of November 1,2002, that the Company had obtained a signed commitment from its major lender,National Rural Utilities Cooperative Finance Corporation, to refinance its $28million line of credit.

 

Reporting on November 5,2002, that the Company learned that on October 30, 2002, Lamar ElectricCooperative Association had filed a lawsuit seeking a declaratory judgment inorder to terminate the Agreement to Combine without any obligation to reimbursethe Company for the costs and expenses it incurred in attempting to completethe combination.

 

Reporting that the Companyreceived notification on November 14, 2002, from the attorney representingLamar Electric Cooperative Association that Lamar terminated the ManagementService Agreement between Lamar and the Company.

 

37

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**Exhibits**

 
| **Exhibit No.** |   | **Item**                                                                                                                                                                                                                                                  |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 3.1     |   | Articles of Incorporation of the Company  and amendments thereto(1)                                                                                                                                                                                       |
| Exhibit 3.2     |   | Bylaws of the Company(1)                                                                                                                                                                                                                                  |
| Exhibit 3.3     |   | Restated and Amended Articles of  Incorporation of the Cooperative(1)                                                                                                                                                                                     |
| Exhibit 3.4     |   | Bylaws of the Cooperative(1)                                                                                                                                                                                                                              |
| Exhibit 3.5     |   | Amended and Restated Bylaws of the  Company(1)                                                                                                                                                                                                            |
| Exhibit 3.6     |   | Amended and Restated Articles of  Incorporation of the Company(1)                                                                                                                                                                                         |
| Exhibit 3.7     |   | Articles of Amendment to the Amended and  Restated Articles of Incorporation of the Company(1)                                                                                                                                                            |
| Exhibit 3.8     |   | Amended and Restated Bylaws of the  Company(1)                                                                                                                                                                                                            |
| Exhibit 5.1     |   | Opinion of Ronald W. Lyon(1)                                                                                                                                                                                                                              |
| Exhibit 8.1     |   | Tax Opinion of Looper Reed & McGraw, a  Professional Corporation(1)                                                                                                                                                                                   |
| Exhibit 10.1    |   | Second Amendment to Transaction Documents  dated November 9, 1994, between Southwestern Public Service Company, the  Cooperative, et. al.(1)                                                                                                              |
| Exhibit 10.2    |   | Restated Mortgage and Security Agreement  dated September 21, 1988, made by and between the Cooperative and National  Rural Utilities Cooperative Finance Corporation(1)                                                                                  |
| Exhibit 10.3    |   | Second Restated Mortgage and Security  Agreement dated October 24, 1995, made by and between the Cooperative and  National Rural Utilities Cooperative Finance Corporation(1)                                                                             |
| Exhibit 10.4    |   | Loan Agreement dated October, 1995, between  the Cooperative and National Rural Utilities Cooperative Finance  Corporation(1)                                                                                                                             |
| Exhibit 10.5    |   | First Amendment to Loan Agreement dated as  of October 28, 1997, between the Cooperative and National Rural Utilities  Cooperative Finance Corporation(1)                                                                                                 |
| Exhibit 10.6    |   | Loan Agreement dated as of June 22, 2000,  between the Cooperative and National Rural Utilities Cooperative Finance  Corporation and amendment.(1)                                                                                                        |
| Exhibit 10.7    |   | Loan Agreement dated December 13, 1994,  between the Cooperative and National Rural Utilities Cooperative Finance  Corporation(1)                                                                                                                         |
| Exhibit 10.8    |   | Loan Agreement dated March 30, 1993 between  the Cooperative and National Rural Utilities Cooperative Finance  Corporation(1)                                                                                                                             |
| Exhibit 10.9    |   | Loan Agreement dated March 10, 1992, TX  107-A-9025, between the Cooperative and National Rural Utilities Cooperative  Finance Corporation(1)                                                                                                             |
| Exhibit 10.10   |   | Loan Agreement dated May 17, 1990, between  the Cooperative and National Rural Utilities Cooperative Finance  Corporation(1)                                                                                                                              |
| Exhibit 10.11   |   | Loan Agreement dated March 22, 1990 between  the Cooperative and National Rural Utilities Cooperative Finance Corporation(1)                                                                                                                              |
| Exhibit 10.12   |   | Notice of Meeting and Proxy Statement for  Special Meeting held October 20, 1998(1)                                                                                                                                                                       |
| Exhibit 10.13   |   | Commitment letter dated as of February 11,  2000 between National Cooperative Services Corporation and Cap Rock Energy  Corporation for credit facilities associated with the purchase of certain  electric assets owned by Citizens Utilities Company(1) |
| Exhibit 10.14   |   | Loan Agreement dated March 10, 1992, TX  107-A-9026, between the Cooperative and National Rural Utilities Cooperative  Finance Corporation(1)                                                                                                             |
| Exhibit 10.17   |   | Power Sale Agreement dated May 1, 1999,  between the Cooperative and Electric Clearinghouse, Inc.(1)                                                                                                                                                      |
| Exhibit 10.18   |   | Wholesale Power Supply and Services  Contract dated April 16, 1997 Between Texas New Mexico Power Company and the  Cooperative(1)                                                                                                                         |
| Exhibit 10.19   |   | Southwestern Public Service Company  Wholesale Full Requirements Service Rate Schedule and related Agreement, as  amended, with the Cooperative(1)                                                                                                        |
| Exhibit 10.20   |   | Ordinance of the City of Greenville, Texas  Granting to the Cooperative a franchise for the transmission and distribution  of electricity(1)                                                                                                              |
| Exhibit 10.21   |   | Ordinance of the City of Midland, Texas  Granting to the Cooperative a franchise for the transmission and distribution  of electricity(1)                                                                                                                 |
| Exhibit 10.22   |   | Ordinance of the City of Stanton, Texas  Granting to the Cooperative a franchise for the transmission and distribution  of electricity(1)                                                                                                                 |
| Exhibit 10.23   |   | Employment Contract between the Cooperative  and Ulen North(1)                                                                                                                                                                                            |
| Exhibit 10.24   |   | Employment Contract between the Cooperative  and David W. Pruitt(1)                                                                                                                                                                                       |

 

38

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| **Exhibit No.** |   | **Item**                                                                                                                                                             |
|-----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 10.25   |   | Achievement Based Compensation Agreement of  the Cooperative dated August 28, 1994(1)                                                                                |
| Exhibit 10.26   |   | Achievement Based Compensation Agreement of  the Cooperative dated October 27, 1992(1)                                                                               |
| Exhibit 10.27   |   | The Cooperatives Supplemental Executive  Deferred Compensation Retirement Plan(1)                                                                                    |
| Exhibit 10.28   |   | Cap Rock Energy Corporation 2001 Stock  Incentive Plan(1)                                                                                                            |
| Exhibit 10.29   |   | Cap Rock Energy Corporation 2001 Employee  Stock Purchase Plan(1)                                                                                                    |
| Exhibit 10.30   |   | Form of Equity & Membership Redemption  Options(1)                                                                                                               |
| Exhibit 10.31   |   | Form of Equity Redemption Options(1)                                                                                                                                 |
| Exhibit 10.32   |   | Agreement for Purchase and Sale dated  February 7, 2000, by and among Walter Mickelson, et al., Multimedia  Development Corporation and New West Resources, Inc.(1)  |
| Exhibit 10.33   |   | Stock Acquisition Agreement dated January  1, 2001, between Thomas E. Kelly, Richard C. Skillern, Johnny D. Grimes,  Billy D. Grimes and New West Resources, Inc.(1) |
| Exhibit 10.34   |   | Consolidating Loan Agreement dated March  30, 1993 between Cap Rock Electric Cooperative, Inc. and National Rural  Utilities Cooperative Finance Corporation(1)      |
| Exhibit 10.35   |   | Integrated Supply Agreement between Cap  Rock Electric Cooperative, Inc. and Temple, Inc.(1)                                                                         |
| Exhibit 10.36   |   | Employment Contract between the Cooperative  and Mickey Sims(1)                                                                                                      |
| Exhibit 10.37   |   | Amendment to Line of Credit Agreement dated  June 27, 1997 between National Rural Utilities Cooperative Finance Corporation  and the Cooperative(1)                  |
| Exhibit 10.38   |   | Loan Agreement dated March 10, 1992, TX  107-A-9027, between the Cooperative and National Rural Utilities Cooperative  Finance Corporation(1)                        |
| Exhibit 10.39   |   | Achievement Based Compensation Contract of  the Cooperative dated August 22, 2000(1)                                                                                 |
| Exhibit 10.40   |   | Loan Agreement dated March 10, 1992, TX  107-A-9024, between Cooperative and National Rural Utilities Cooperative  Finance Corporation(1)                            |
| Exhibit 10.41   |   | Wholesale Power Agreement dated June 25,  1977, between Lower Colorado River Authority and McCulloch Electric  Cooperative, Inc.(1)                                  |
| Exhibit 10.42   |   | Amendment to Wholesale Power Agreement  dated September 28, 1987 between Lower Colorado River Authority and McCulloch  Electric Cooperative, Inc.(1)                 |
| Exhibit 10.43   |   | Director Compensation Plan of the  Company(1)                                                                                                                        |
| Exhibit 10.44   |   | Trust Agreement for the Cooperative  Supplemental Executive Deferred Compensation Retirement Plan(1)                                                                 |
| Exhibit 10.45   |   | CFC Secured Revolving Line of Credit  Agreement dated June 24, 1997(1)                                                                                               |
| Exhibit 10.46   |   | Achievement Based Compensation Agreement of  the Cooperative dated June 29, 1999(1)                                                                                  |
| Exhibit 10.47   |   | Agreement to Combine McCulloch and Cap Rock  Electric Cooperatives dated June 30, 1999(1)                                                                            |
| Exhibit 10.48   |   | Management Service Agreement between  Cooperative and Lamar Electric Cooperative Association(1)                                                                      |
| Exhibit 10.49   |   | Notice of Annual Meeting and Proxy  Statement for Members of McCulloch Electric Cooperative held on August 21,  1999(1)                                              |
| Exhibit 10.50   |   | Agreement to Combine Lamar and Cap Rock  Electric Cooperatives dated October 28, 1999(1)                                                                             |
| Exhibit 10.51   |   | Loan Agreement between NewWest Resources,  Inc, Cap Rock Electric Cooperative, Inc. and Bank United Texas FSB dated July  12, 2000(1)                                |
| Exhibit 10.52   |   | Unconditional Guaranty from Cap Rock  Electric Cooperative to Bank United Texas FSB dated July 12, 2000(1)                                                           |
| Exhibit 10.53   |   | Lamar County Electric Cooperative  Association Notice of Special Meeting and Proxy Statement for Special Meeting  held December 14, 1999(1)                          |
| Exhibit 10.54   |   | Signature Leasing, Inc. Master Lease  Agreement dated April 1, 2000(1)                                                                                               |
| Exhibit 10.55   |   | Personal Services Agreement between Leonard  S. Herring and the Cooperative dated December 16, 1999(1)                                                               |
| Exhibit 10.56   |   | Term Loan Agreement between Eddins-Walcher  Company, Frank’s Fuels, United Fuel & Energy Corporation, and NewWest  Resources dated July 12, 2000(1)         |
| Exhibit 10.57   |   | NewCorp Resources Electric Cooperative Open  Access Transmission Tariff(1)                                                                                           |
| Exhibit 10.58   |   | Supplement to the Restated Mortgage and  Security Agreement between the Cooperative and CFC dated May 17, 1990(1)                                                    |
| Exhibit 10.59   |   | Loan Agreement between Cap Rock Cooperative  Finance Corporation and CFC dated June 22, 1999(1)                                                                      |
| Exhibit 10.60   |   | Confirmation Letter between Electric  Clearinghouse, Inc. and the Cooperative dated May 27, 1999(1)                                                                  |
| Exhibit 10.61   |   | Service Agreement Rate Schedule WP between  NewCorp Resources and Cap Rock Electric Cooperative dated March 31, 1995(1)                                              |

 

39

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| **Exhibit No.** |   | **Item**                                                                                                                                                     |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 10.62   |   | Transaction Agreement dated as of September  9, 1993 between Southwestern Public Service Company, the Cooperative and OTP,  Inc.(1)                          |
| Exhibit 10.63   |   | Assignment of Certificate of Convenience  and Necessity by the Cooperative to NewCorp Resources dated January 17,  1996(1)                                   |
| Exhibit 10.64   |   | Supplemental Agreement between NewCorp  Resources and the Cooperative dated April 25, 1995(1)                                                                |
| Exhibit 10.65   |   | Third Amendment to Transaction Documents by  and among Southwestern Public Service Company, the Cooperative, NewCorp  Resources et al dated March 3, 1995(1) |
| Exhibit 10.66   |   | Assignment of Wholesale Power Contract from  the Cooperative to NewCorp Resources dated March 3, 1995(1)                                                     |
| Exhibit 10.67   |   | QSE and Ancillary Services Agreement  between the Cooperative and Garland Power and Light dated June 1, 2001(1)                                              |
| Exhibit 10.68   |   | Letter of Intent between the Company and  Boeing Capital Corporation dated June 5, 2001(1)                                                                   |
| Exhibit 10.69   |   | Employment Contract between the Company and  Lee D. Atkins(1)                                                                                                |
| Exhibit 10.70   |   | Employment Contract between the Company and  Ronald W. Lyon(1)                                                                                               |
| Exhibit 10.71   |   | Employment Contract between the Company and  Sam Prough(1)                                                                                                   |
| Exhibit 10.72   |   | Achievement Based Compensation Agreement of  the Cooperative dated August 21, 2001(1)                                                                        |
| Exhibit 10.73   |   | Letter from State Securities Board of the  State of Texas dated December 6, 2001(1)                                                                          |
| Exhibit 10.74   |   | Employment Contract between the Company and  Celia A. Zinn (2)                                                                                               |
| Exhibit 10.75   |   | Cap Rock Energy Corporation Shareholders’  Trust (2)                                                                                                    |
| Exhibit 10.76   |   | Cap Rock Energy Corporation Trust Share  Option Agreement(2)                                                                                                 |
| Exhibit 10.77   |   | Cap Rock Energy Corporation Trust Funding  Agreement(2)                                                                                                      |
| Exhibit 10.78   |   | Supplemental Executive Deferred  Compensation Retirement Plan(2)                                                                                             |
| Exhibit 20.1    |   | Election Form(1)                                                                                                                                             |
| Exhibit 21.1    |   | Subsidiaries of the Company(1)                                                                                                                               |
| Exhibit 23.2    |   | Consent of Ronald W. Lyon is contained in  his opinion filed as Exhibit 5.1 to this registration statement.(1)                                               |
| Exhibit 23.4    |   | Consent of Looper Reed & McGraw(1)                                                                                                                       |
| Exhibit 99.1    |   | Certification Pursuant to 18 U.S.C. Section  1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of  David W. Pruitt(2)               |
| Exhibit 99.2    |   | Certification Pursuant to 18 U.S.C. Section  1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of  Lee D. Atkins(2)                 |

 

----

(1)                                  Previously filed

 

(2)                                  Filed herewith

 

40

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**SIGNATURES**

 

In accordance with the requirements of theSecurities Act of 1934, as amended, the Registrant certifies that it hasreasonable grounds to believe that it meets all of the requirements for filingForm 10K and authorizes this 10K to be signed on its behalf by the undersigned,thereunto duly authorized, in the City of Midland, Texas on April 10, 2003.

 

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

 

Pursuant to the requirements of theSecurities Exchange Act of 1934 this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 
| **Signature**            |   | **Title**                                       |   | **Date**       |
|--------------------------|--------|-------------------------------------------------|--------|----------------|
|                     |   |                                            |   |           |
| /s/ David W. Pruitt      |   | Co-Chairman of the  Board, President and Chief  |   | April 10, 2003 |
| David W. Pruitt          |   | Executive Officer                               |   |           |
|                     |   |                                            |   |           |
| *                        |   | Senior Vice President,  Chief Financial Officer |   | April 10, 2003 |
| /s/ Lee D. Atkins        |   | and Treasurer                                   |   |           |
|                     |   |                                            |   |           |
| *                        |   | Co-Chairman of the Board                        |   | April 10, 2003 |
| /s/ Russell E. Jones     |   |                                            |   |           |
|                     |   |                                            |   |           |
| *                        |   | Director                                        |   | April 10, 2003 |
| /s/ S. D. Buchanan       |   |                                            |   |           |
|                     |   |                                            |   |           |
| *                        |   | Director                                        |   | April 10, 2003 |
| /s/ Floyd L. Ritchey     |   |                                            |   |           |
|                     |   |                                            |   |           |
| *                        |   | Director                                        |   | April 10, 2003 |
| /s/ Michael D. Schaffner |   |                                            |   |           |
|                     |   |                                            |   |           |
| *                        |   | Director                                        |   | April 10, 2003 |
| /s/ Newell W. Tate       |   |                                            |   |           |

 

41

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**CERTIFICATION**

 

I, David W. Pruitt, certifythat:

 

1.                                  I have reviewed this annual report on Form10-K of Cap Rock Energy Corporation;

 

2.                                  Based on my knowledge, this annual reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under such statements were made, not misleading with respect tothe period covered by this annual report;

 

3.                                  Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this annual report;

 

4.                                  The registrant’s other certifying officer andI are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and we have:

 

a)           Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

b)           Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

c)           Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.                                  The registrant’s other certifying officer andI have disclosed, based on our most recent evaluation, to the registrant’sauditors and the audit committee of registrant’s board of directors (or personsperforming the equivalent function):

 

a)           All significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

b)           Any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.                                  The registrant’s other certifying officer andI have indicated in this annual report whether or not there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 

 

Date: April 10, 2003

 

 
|   | By: /s/ David W. Pruitt                                           |   |
|--------|-------------------------------------------------------------------|--------|
|   | David W. Pruitt                                                   |
|   | Co-Chairman of the Board,  President and  Chief Executive Officer |

 

42

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**CERTIFICATION**

 

I, Lee D. Atkins, certifythat:

 

1.                                  I have reviewed this annual report on Form10-K of Cap Rock Energy Corporation;

 

2.                                  Based on my knowledge, this annual reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under such statements were made, not misleading with respect tothe period covered by this annual report;

 

3.                                  Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this annual report;

 

4.                                  The Registrant’s other certifying officer andI are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and we have:

 

a)           Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

b)           Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

c)           Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.                                  The Registrant’s other certifying officer andI have disclosed, based on our most recent evaluation, to the Registrant’sauditors and the audit committee of Registrant’s board of directors (or personsperforming the equivalent function):

 

a)           All significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

b)           Any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.                                  The registrant’s other certifying officer andI have indicated in this annual report whether or not there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 

 

Date: April 10, 2003

 
|   | By: /s/ Lee D. Atkins                                           |
|--------|-----------------------------------------------------------------|
|   | Lee D. Atkins                                                   |
|   | Senior Vice President,  Chief Financial Officers  and Treasurer |

 

43

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**CAP ROCK ENERGY CORPORATIONSCHEDULE II—VALUATION AND QUALIFYING ACCOUNTSALLOWANCE FOR DOUBTFUL ACCOUNTSAMOUNTS 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, 2002           |   | $                                                | 202    |                                            | $      | 113                                         |   | $                                          | 265    |   | $ | 50 |   |
| December 31, 2001           |   | $                                                | 292    |                                            | $      | 107                                         |   | $                                          | 197    |   | $ | 202 |   |
| March 31, 2001              |   | $                                                | 202    |                                            | $      | 228                                         |   | $                                          | 138    |   | $ | 292 |   |

 

44

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**INDEX TO FINANCIAL STATEMENTS**

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

 

F-1

----

 

**INDEPENDENT AUDITORS’ REPORT**

 

To the Board of Directors ofCap Rock Energy Corporation:

 

We have audited the 2002 financial statementsof Cap Rock Energy Corporation and subsidiaries (the Company) as listed in theaccompanying index.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audit.  The 2001 and 2000 financial statements of Cap Rock EnergyCorporation, as listed in the accompanying index, were audited by otherauditors who have ceased operations and whose report, dated March 29, 2002,expressed an unqualified opinion on those financial statements.  That report of other auditors refers to achange in accounting principles related to accounting for derivative financialinstruments.

 

We conducted our audits in accordance withauditing standards generally accepted in the United States of America. Thosestandards require that we plan and perform the audit to obtain reasonable assuranceabout whether the financial statements are free of material misstatement. Anaudit includes examining, on a test basis, evidence supporting the amounts anddisclosures 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 believethat our audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statementsreferred to above present fairly, in all material respects, the financialposition of Cap Rock Energy Corporation as of December 31, 2002, and theresults of its operations and its cash flows for the year then ended, inconformity with accounting principles generally accepted in the United Statesof America.

 

Our audit was made for the purpose of formingan opinion on the basic financial statements taken as a whole.  The Valuation and Qualifying Accounts,Schedule II is presented for purposes of additional analysis and is not arequired part of the basic financial statements.  This information has been subjected to the auditing proceduresapplied in our audit of the basic financial statements and, in our opinion, isfairly stated in all material respects in relation to the basic financialstatements taken as a whole.

 

 
|           | KPMG LLP |
|----------------|----------|
|           |     |
|           |
| Midland, Texas |
| March 28, 2003 |

 

F-2

----

 

This is a copy of the report previously issued by Arthur AndersenLLP.  The report has not been reissued byArthur Andersen LLP nor has Arthur Andersen LLP provided a consent to theinclusion of its report in this annual report on Form 10-K.

 

**REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS**

 

To the Board of Directors of

Cap Rock Electric Cooperative, Inc.:

 

We have audited the accompanying consolidatedbalance sheets of Cap Rock Electric Cooperative, Inc. and subsidiaries (the“Cooperative”) as of December 31, 2001, and March 31, 2001, and the relatedconsolidated statements of operations, changes in equities and margins and cashflows for the nine months ended December 31, 2001, and each of the two years inthe period ended March 31, 2001. These financial statements and the schedulereferred to below are the responsibility of the Cooperative’s management. Ourresponsibility is to express an opinion on these financial statements andschedule based on our audits.

 

We conducted our audits in accordance withauditing standards generally accepted in the United States. Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures 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 believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, thefinancial position of the  Cooperativeas of December 31, 2001, and March 31, 2001, and the results of  its operations and its cash flows for thenine months ended December 31,  2001,and each of the two years in the period ended March 31, 2001, in  conformity with accounting principlesgenerally accepted in the United States.

 

Our audit was made for the purpose of formingan opinion on the basic financial statements taken as a whole. The Valuationand Qualifying Accounts, Schedule II is presented for purposes of additionalanalysis and is not a required part of the basic financial statements. Thisinformation has been subjected to the auditing procedures applied in our auditof the basic financial statements and, in our opinion, is fairly stated in allmaterial respects in relation to the basic financial statements taken as awhole.

 

As explained in Note 1. to the consolidatedfinancial statements,  effective April1, 2001, the Cooperative adopted Statement of Financial  Accounting Standards No. 133, “Accountingfor Derivative Instruments and  HedgingActivities,” as amended.

 

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

 

F-3

----

 

**CAP ROCK ENERGY CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
|                                                             |   | **YEAR ENDED  DECEMBER 31,  2002**                               |   | **NINE MONTHS  ENDED  DECEMBER 31,  2001** |   | **YEAR ENDED  MARCH 31,  2001** |   |
|------------------------------------------------------------------|--------|------------------------------------------------------------------|--------|--------------------------------------------|--------|---------------------------------|--------|
|                                                             |   | **Successor**                                                    |   | **Predecessor**                            |   | **Predecessor**                 |   |
|                                                             |   | **- - - (Thousands of dollars except per share  amounts) - - -** |   |
|                                                             |   |                                                             |   |
| **Operating  Revenues:**                                         |   |                                                             |   |                                       |   |                            |   |
| Electric sales                                                   |   | $                                                                | 73,335 |                                       | $      | 52,326                          |   | $ | 70,742 |   |
| Gas sales and royalty  income                                    |   | —                                                           |   | —                                     |   | 486                             |   |
| Other                                                            |   | 1,302                                                            |   | 796                                        |   | 1,237                           |   |
| Total operating revenues                                         |   | 74,637                                                           |   | 53,122                                     |   | 72,465                          |   |
| **Operating  Expenses:**                                         |   |                                                             |   |                                       |   |                            |   |
| Purchased power                                                  |   | 36,433                                                           |   | 28,194                                     |   | 44,967                          |   |
| Operations and  maintenance                                      |   | 7,327                                                            |   | 5,828                                      |   | 6,961                           |   |
| Administrative and  general                                      |   | 7,144                                                            |   | 3,326                                      |   | 4,180                           |   |
| Depreciation and  amortization                                   |   | 6,134                                                            |   | 4,568                                      |   | 6,171                           |   |
| Property taxes                                                   |   | 1,367                                                            |   | 997                                        |   | 1,408                           |   |
| Write off of investment  in Citizens (Note 6)                    |   | —                                                           |   | —                                     |   | 2,815                           |   |
| Write off of investment  in MDC (Note 7)                         |   | —                                                           |   | —                                     |   | 1,063                           |   |
| Impairment of Lamar  combination costs (Note 5)                  |   | 1,357                                                            |   | —                                     |   | —                          |   |
| Other                                                            |   | 202                                                              |   | 229                                        |   | 579                             |   |
| Total operating expenses                                         |   | 59,964                                                           |   | 43,142                                     |   | 68,144                          |   |
| **Operating  Income**                                            |   | 14,673                                                           |   | 9,980                                      |   | 4,321                           |   |
| **Other  Income (Expense):**                                     |   |                                                             |   |                                       |   |                            |   |
| Allocation of income  from associated organizations              |   | 478                                                              |   | 1,205                                      |   | 823                             |   |
| Interest expense, net of  capitalized interest                   |   | (7,103                                                           | )      | (8,004                                     | )      | (11,832                         | )      |
| Interest and other  income                                       |   | 1,027                                                            |   | 1,161                                      |   | 1,411                           |   |
| Equity earnings in MAP  (Notes 9 and 24)                         |   | 115                                                              |   | 88                                         |   | 127                             |   |
| Total other income  (expense)                                    |   | (5,483                                                           | )      | (5,550                                     | )      | (9,471                          | )      |
| **Income  (Loss) before income taxes**                           |   | 9,190                                                            |   | 4,430                                      |   | (5,150                          | )      |
| Income tax expense                                               |   | 414                                                              |   | —                                     |   | —                          |   |
| **Income  (loss) before extraordinary item**                     |   | 8,776                                                            |   | 4,430                                      |   | (5,150                          | )      |
| Extraordinary gain on  early extinguishment of debt (Note 13)    |   | —                                                           |   | —                                     |   | 969                             |   |
| **Net  Income (Loss)**                                           |   | $                                                                | 8,776  |                                       | $      | 4,430                           |   | $ | (4,181 | ) |
| **Pro  forma Basic and Diluted Earnings Per Share (Unaudited):** |   |                                                             |   |                                       |   |                            |   |
| Income (loss) from  continuing operations                        |   |                                                             |   | $                                          | 3.40   |                            | $      | (3.95 | ) |
| Extraordinary item                                               |   |                                                             |   | —                                     |   | 0.74                            |   |
| Net income (loss) per  share                                     |   |                                                             |   | $                                          | 3.40   |                            | $      | (3.21 | ) |
| Pro forma shares  outstanding                                    |   |                                                             |   | 1,302,355                                  |   | 1,302,355                       |   |
| **Basic  and Diluted Earnings Per Share:**                       |   |                                                             |   |                                       |   |                            |   |
| Net income                                                       |   | $                                                                | 6.74   |                                       |   |                            |   |   |
| Number of common shares  used in computing earnings per share    |   | 1,302,355                                                        |   |                                       |   |                            |   |
|                                                                  |        |                                                                  |        |                                            |        |                                 |        |  |  |  |  |

 

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

 

F-4

----

 

**CAP ROCK ENERGY CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

 
|                                                                                                               |   | **DECEMBER 31,**           |    |
|--------------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|
|                                                                                                               |   | **2002**                   |    | **2001** |   |
|                                                                                                               |   | **Successor**              |    | **Predecessor** |   |
|                                                                                                               |   | **(Thousands of dollars)** |    |
|                                                                                                               |   |                       |    |   |   |
| **ASSETS**                                                                                                         |   |                       |    |   |   |
| **Current  Assets:**                                                                                               |   |                       |    |   |   |
| Cash                                                                                                               |   | $                          | 9,899   |   | $ | 5,498 |   |
| Accounts receivable:                                                                                               |   |                       |    |   |   |
| Electric sales, net                                                                                                |   | 4,723                      |    | 3,642 |   |
| Other                                                                                                              |   | 337                        |    | 497 |   |
| Current portion of notes  receivable (Note 9 and 15)                                                               |   | 12,490                     |    | 1,000 |   |
| Purchased power subject  to recovery                                                                               |   | 3,501                      |    | — |   |
| Other current assets  (Note 8)                                                                                     |   | 7,805                      |    | 1,419 |   |
| **Total  current assets**                                                                                          |   | 38,755                     |    | 12,056 |   |
|                                                                                                               |   |                       |    |   |   |
| **Utility  plant, net (Note 10)**                                                                                  |   | 157,323                    |    | 164,547 |   |
| **Investments  and notes receivable (Note 9)**                                                                     |   | 12,490                     |    | 25,904 |   |
| **Nonutility  property, net (Note 11)**                                                                            |   | 1,564                      |    | 1,623 |   |
| **Other  assets (Note 12)**                                                                                        |   | 1,162                      |    | 10,329 |   |
| **Total  Assets**                                                                                                  |   | $                          | 211,294 |   | $ | 214,459 |   |
|                                                                                                               |   |                       |    |   |   |
| **LIABILITIES AND EQUITY**                                                                                         |   |                       |    |   |   |
|                                                                                                               |   |                       |    |   |   |
| **Current  Liabilities:**                                                                                          |   |                       |    |   |   |
| Current portion of  long-term debt                                                                                 |   | $                          | 33,924  |   | $ | 9,131 |   |
| Accounts payable:                                                                                                  |   |                       |    |   |   |
| Purchased power                                                                                                    |   | 3,381                      |    | 3,057 |   |
| Other                                                                                                              |   | 1,805                      |    | 3,165 |   |
| Equity redemption  credits (Note 2)                                                                                |   | 732                        |    | 827 |   |
| Purchased power cost  subject to refund                                                                            |   | —                     |    | 387 |   |
| Accrued and other  current liabilities (Note 18)                                                                   |   | 3,054                      |    | 3,167 |   |
| Current income tax  payable (Note 27)                                                                              |   | 414                        |    | — |   |
| **Total  current liabilities**                                                                                     |   | 43,310                     |    | 19,734 |   |
|                                                                                                               |   |                       |    |   |   |
| **Long-Term  Debt, Net of Current Portion:**                                                                       |   |                       |    |   |   |
| Mortgage notes (Note 13)                                                                                           |   | 147,744                    |    | 123,414 |   |
| Line of credit (Note 13)                                                                                           |   | —                     |    | 28,000 |   |
| Capital lease -  transmission system (Note 14)                                                                     |   | —                     |    | 17,632 |   |
| Note payable and other  capital leases (Note 15)                                                                   |   | 308                        |    | 12,686 |   |
| **Total  long-term debt**                                                                                          |   | 148,052                    |    | 181,732 |   |
|                                                                                                               |   |                       |    |   |   |
| **Deferred  Credits  (Note 20)**                                                                              |   | 5,194                      |    | 5,321 |   |
|                                                                                                               |   |                       |    |   |   |
| **Stockholders’  Equity:**                                                                                    |   |                       |    |   |   |
| Common stock, par value  $.01 per share,   50,000,000 shares authorized,   1,302,355 shares issued and outstanding |   | 13                         |    | — |   |
| Preferred stock, par  value $1 per share,   50,000,000 shares authorized,   no shares issued or outstanding        |   | —                     |    | — |   |
| Paid in capital                                                                                                    |   | 5,949                      |    | — |   |
| Retained earnings                                                                                                  |   | 8,776                      |    | — |   |
| **Total  stockholders’ equity**                                                                               |   | 14,738                     |    | — |   |
|                                                                                                               |   |                       |    |   |   |
| **Equities  and Margins**                                                                                          |   | —                     |    | 7,672 |   |
| **Total  Liabilities and Equity**                                                                                  |   | $                          | 211,294 |   | $ | 214,459 |   |

 

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

 

F-5

----

 

**CAP ROCK ENERGY CORPORATION**

**CONSOLIDATEDSTATEMENT OF EQUITY**

 
|                                                                                                            |             | **(Thousands of dollars except number of shares)** |      |                 |
|-----------------------------------------------------------------------------------------------------------------|------------------|----------------------------------------------------|-----------|----------------------|
|                                                                                                            |             | **Successor**                                      |      | **Predecessor**      |   |   |
|                                                                                                            |             |                                               |      | **Paid in  Capital** |   | **Retained  Earnings** |   | **Total  Stockholders**’**Equity** |   | **Patronage  Capital  Credits** |   | **Other  Equities and  Margins** |   | **Patronage Capital  Obligated to be  converted to  Shareholder Equity** |   | **Total  Margins  and  Equities** |   |   |
|                                                                                                            |             |                                               |      |                 |   |   |   |   |   |   |
|                                                                                                            | **Common Stock** |                                               |      |                 |   |   |   |   |   |   |
|                                                                                                            | **# shares**     |                                               | **Value** |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Balance, March 31, 2000**                                                                                     |             |                                               |      |                 |   |   |   |   |   |   |   | $ | 18,502 |   | $ | (5,843 | ) |   |   | $ | 12,659 |   |
| Net loss                                                                                                        |             |                                               |      |                 |   |   |   |   |   |   |   | — |   | (4,181 | ) |   |   | (4,181 | ) |
| Patronage capital credits retired for electric credits                                                          |             |                                               |      |                 |   |   |   |   |   |   |   | (2,401 | ) | — |   |   |   | (2,401 | ) |
| Patronage capital credits retired for cash                                                                      |             |                                               |      |                 |   |   |   |   |   |   |   | (621 | ) | 219 |   |   |   | (402 | ) |
| **Balance, March 31, 2001**                                                                                     |             |                                               |      |                 |   |   |   |   |   |   |   | 15,480 |   | (9,805 | ) |   |   | 5,675 |   |
| Net income for nine months                                                                                      |             |                                               |      |                 |   |   |   |   |   |   |   | — |   | 4,430 |   |   |   | 4,430 |   |
| Patronage capital credits retired for electric credits                                                          |             |                                               |      |                 |   |   |   |   |   |   |   | (909 | ) | — |   |   |   | (909 | ) |
| Patronage capital credits retired for cash                                                                      |             |                                               |      |                 |   |   |   |   |   |   |   | (2,181 | ) | 657 |   |   |   | (1,524 | ) |
| Patronage capital obligated to be converted into shareholder equity  (Note 2)                                   |             |                                               |      |                 |   |   |   |   |   |   |   | (12,390 | ) | — |   | 12,390 |   | — |   |
| **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 are an integralpart of these consolidated financial statements.

 

 

F-6

----

 

**CAP ROCK ENERGY CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS**

 

 
|                                                                                      |   | **YEAR ENDED  DECEMBER 31,  2002**                                                  |   | **NINE MONTHS  ENDED  DECEMBER 31,  2001** |   | **YEAR ENDED  MARCH 31,  2001** |   |
|-------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|---------------------------------|--------|
|                                                                                      |   | **Successor**                                                                       |   | **Predecessor**                            |   | **Predecessor**                 |   |
|                                                                                      |   | **- - - - - - - - - -- - -****(Thousands of dollars)****- - - - - - - - - - - - -** |   |
| **Cash Flows From  Operating Activities:**                                                |   |                                                                                |   |                                       |   |                            |   |
| Net income (loss)                                                                         |   | $                                                                                   | 8,776  |                                       | $      | 4,430                           |   | $ | (4,181 | ) |
| Adjustments to reconcile net  income (loss) to net cash provided by operating activities: |   |                                                                                |   |                                       |   |                            |   |
| Depreciation and amortization                                                             |   | 9,253                                                                               |   | 8,328                                      |   | 10,863                          |   |
| Write off of investments in  proposed acquisitions                                        |   | 1,357                                                                               |   | —                                     |   | 1,326                           |   |
| Equity earnings in Map                                                                    |   | (115                                                                                | )      | (88                                        | )      | (127                            | )      |
| Gain on extinguishment of debt                                                            |   | —                                                                              |   | —                                     |   | (969                            | )      |
| Change in:                                                                                |   |                                                                                |   |                                       |   |                            |   |
| Other assets/deferred credits                                                             |   | 5,909                                                                               |   | 17                                         |   | (2,251                          | )      |
| Accounts receivable                                                                       |   | (921                                                                                | )      | 2,370                                      |   | (2,491                          | )      |
| Purchased power cost subject to  refund                                                   |   | (3,888                                                                              | )      | (3,808                                     | )      | 1,649                           |   |
| Other current assets                                                                      |   | (6,386                                                                              | )      | (926                                       | )      | (40                             | )      |
| Accounts payable and accrued  expenses                                                    |   | (735                                                                                | )      | 934                                        |   | 3,180                           |   |
| Other                                                                                     |   | —                                                                              |   | —                                     |   | 63                              |   |
| Net cash provided by operating  activities                                                |   | 13,250                                                                              |   | 11,257                                     |   | 7,022                           |   |
|                                                                                      |   |                                                                                |   |                                       |   |                            |   |
| **Cash Flows From  Investing Activities**                                                 |   |                                                                                |   |                                       |   |                            |   |
| Utility plant additions, net                                                              |   | (1,517                                                                              | )      | (4,257                                     | )      | (9,714                          | )      |
| Proceeds from liquidation of  investments, net of additions                               |   | 1,043                                                                               |   | (76                                        | )      | (360                            | )      |
| Issuance of notes receivable                                                              |   | —                                                                              |   | —                                     |   | (16,500                         | )      |
| Collection of notes receivable                                                            |   | 1,000                                                                               |   | 2,100                                      |   | 733                             |   |
| Restricted cash investment                                                                |   | —                                                                              |   | —                                     |   | 1,900                           |   |
| Other                                                                                     |   | —                                                                              |   | —                                     |   | 527                             |   |
| Net cash provided by (used in)  investing activities                                      |   | 526                                                                                 |   | (2,233                                     | )      | (23,414                         | )      |
|                                                                                      |   |                                                                                |   |                                       |   |                            |   |
| **Cash Flows From  Financing Activities:**                                                |   |                                                                                |   |                                       |   |                            |   |
| Net borrowings under lines of  credit                                                     |   | —                                                                              |   | 40                                         |   | 1,781                           |   |
| Proceeds from mortgage notes                                                              |   | —                                                                              |   | —                                     |   | 21,027                          |   |
| Proceeds from other long-term debt  and capital leases                                    |   | 534                                                                                 |   | —                                     |   | 15,000                          |   |
| Payments on mortgage notes                                                                |   | (3,034                                                                              | )      | (2,320                                     | )      | (8,310                          | )      |
| Payments on other long-term debt  and capital leases                                      |   | (6,387                                                                              | )      | (4,377                                     | )      | (5,128                          | )      |
| Retirement of member equity                                                               |   | (488                                                                                | )      | (2,605                                     | )      | (3,773                          | )      |
| Net cash provided by (used in)  financing activities                                      |   | (9,375                                                                              | )      | (9,262                                     | )      | 20,597                          |   |
|                                                                                      |   |                                                                                |   |                                       |   |                            |   |
| **Increase (Decrease)  in Cash and Cash Equivalents:**                                    |   | 4,401                                                                               |   | (238                                       | )      | 4,205                           |   |
| Cash at beginning of period                                                               |   | 5,498                                                                               |   | 5,736                                      |   | 1,531                           |   |
| Cash at end of period                                                                     |   | $                                                                                   | 9,899  |                                       | $      | 5,498                           |   | $ | 5,736 |   |
|                                                                                      |   |                                                                                |   |                                       |   |                            |   |
| **Supplemental Cash  Flow Information**                                                   |   |                                                                                |   |                                       |   |                            |   |
| Cash paid during the period for  interest                                                 |   | $                                                                                   | 8,611  |                                       | $      | 8,320                           |   | $ | 11,778 |   |

 

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

 

F-7

----

 

**CAP ROCK ENERGY CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31, 2002 AND 2001, AND MARCH 31,2001**

 

**1. SUMMARY OF  SIGNIFICANTACCOUNTING POLICIES**

 

Cap Rock Energy Corporation, Inc. (the“Company” and the “Successor”) was formed in December 1998 in accordance with aconversion plan to reorganize a member owned electric cooperative, Cap RockElectric Cooperative, Inc. (the “Cooperative” or the “Predecessor”) to ashareholder owned business corporation. The Company assumed the business of the Cooperative, which wasincorporated as an electric cooperative in the State of Texas in 1939 to provideelectric distribution and power to its members.  The Company provides service to over 35,000 meters in 28 countiesin Texas.  Its customers are located inthe Midland-Stanton area of West Texas, the Central Texas area around Brady,and in Northeast Texas in Hunt, Collin and Fannin Counties.  The Company, through its subsidiaries, alsohas transmission assets and is engaged in providing various electric servicesto customers, as well as miscellaneous non-electric services.

 

**Presentation and Principles of Consolidation**

 

The accompanying consolidated financialstatements include the accounts of the Company, Cap Rock Energy Corporation(Energy) and its wholly-owned subsidiaries, NewCorp Resources ElectricCooperative, Inc. (“NewCorp”), Cap Rock Cooperative Finance Corporation(“CRCFC”), Capstar Communications and the Cooperative.  The financial statements presented for theperiods ending on or before December 31, 2001, are the historical consolidatedfinancial statements of the Cooperative, and the consolidated financialstatements for periods ending after January 1, 2002, are those of theSuccessor, Cap Rock Energy Corporation. The Predecessor’s consolidated financial statements include the accountsof the Cooperative and its wholly-owned subsidiaries, Cap Rock EnergyCorporation, Capstar Resources, Inc. (“Capstar”), Capstar Communications, Cap Rock Utilities, Inc. (“Cap RockUtilities”), New West Resources, Inc. (“New West”), CRCFC and NewCorp.

 

Effective June 30, 2001, Capstar, Cap RockUtilities and New West were merged into NewCorp.

 

All significant intercompany accounts andtransactions have been eliminated in consolidation.  Unless otherwise indicated, all references to the Company willinclude any and all activities of its Predecessor.

 

**Basis of Accounting**

 

The Company’s accounting records, and thoseof the Predecessor, are maintained in accordance with the Uniform System ofAccounts as prescribed by the Federal Energy Regulatory Commission (“FERC”) forClass A and B electric utilities.  TheCompany’s accounting policies, and those of the Predecessor, conform togenerally accepted accounting principles as applied in the case of regulatedpublic utilities in the United States and are in accordance with the accountingrequirements and ratemaking practices of FERC. Because the rates charged by theCompany are regulated by its Board of Directors and certain other regulators,the Company prepares its financial statements in accordance with the provisionsof SFAS No. 71, “Accounting for the Effects of Certain Types of Regulations.”SFAS No. 71 requires a cost based, rate-regulated enterprise to reflect theimpact of regulatory decisions in its financial statements. In certaincircumstances, SFAS No. 71 requires that certain costs and/or obligations bereflected in a deferral account on the balance sheet and not reflected in thestatement of income or loss until matching revenues are recognized. It is theCompany’s policy to assess the recoverability of costs recognized as regulatoryassets and the Company’s ability to continue to account for its activities inaccordance with SFAS No. 71, based on each regulatory action and the criteriaset forth in SFAS No. 71.

 

Regulatory assets andliabilities are those assets and liabilities recognized under SFAS No. 71 onlyby a regulated entity.  At December 31,2002, the Company had one regulatory liability and one regulatory asset.  The regulatory asset was a power costrecovery receivable of $3.5 million and the regulatory liability was deferredrevenue of $2.2 million.  At December 312001, the Company had one regulatory asset and two regulatory liabilities.  The regulatory asset was a fuel pricederivative of $482,000 and the regulatory liabilities were deferred revenue of$1.3 million and power cost subject to refund of $387,000.

 

F-8

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**Change in Year End**

 

During the quarter ended December 31, 2001,the Board of Directors of the Cooperative adopted a resolution changing thedate of the Cooperative’s and its subsidiaries’ fiscal year-end from March 31to December 31, effective December 31, 2001. For comparative purposes,unaudited statements of operations for the nine months ended December 31, 2000,and year ended December 31, 2001, has been included for the Predecessor as shownin Note 4.

 

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

 

Pro forma basic and diluted earnings (loss)per share (unaudited) are presented in the accompanying consolidated statementsof operations for the nine months ended December 31, 2001, and the year endedMarch 31, 2001.  Pro forma basic anddiluted earnings per share are based on the assumption that the Cooperative wasconverted from a member owned cooperative to a shareholder owned businesscorporation and 1,302,355 shares of common stock were issued for members’ownership interests on April 1, 2001 and 2000. As discussed in Note 2, such conversion occurred in February 2002.

 

**Earnings Per Share**

 

The Company’s basic and diluted earnings pershare (“EPS”) have been calculated in accordance with SFAS No. 128, “EarningsPer Share.”  Basic and diluted EPS forthe year ended December 31, 2002, are not materially different.  Basic EPS is based on the weighted-averagenumber of common shares outstanding. Diluted EPS is based on the weighed-average number of common sharesoutstanding and common stock equivalents which would arise from the exercise ofstock options.  There are no potentiallydilutive common stock equivalents outstanding.

 

As of March 28, 2003, there were 59,000shares of common stock that had been tendered pursuant to the Company’srepurchase offer.  See Note 16.

 

**Use of Estimates**

 

The preparation of the Company’s consolidatedfinancial statements, in conformity with accounting principles generallyaccepted in the United States, requires management to make estimates andassumptions that affect the reported amounts in the consolidated financialstatements. Actual results could differ from those estimates.

 

**Cash and Cash Equivalents**

 

The Company considers all highly liquidinvestments purchased with original maturities of three months or less to becash equivalents. The carrying amount of cash equivalents approximates marketvalue due to the short-term maturity of these investments.

 

**Allowance for Doubtful Accounts**

 

The Company provides an allowance fordoubtful accounts receivable that are estimated to be uncollectible based onhistorical trends for each rate class. As of December 31, 2002 and 2001, the allowance for doubtful accountswas $50,000 and $202,000, respectively. Bad debt expense for the year endedDecember 31, 2002, nine months ended December 31, 2001, and the year endedMarch 31, 2001, was $120,000, $102,000 and $228,000 respectively.

 

**Investments in Associated Organizations**

 

Investments in associated organizationsrelate primarily to required membership certificates and the accumulatedcapital of National Rural Utilities Cooperative Finance Corporation (“CFC”) andTexas Electric Cooperative, Inc. (“TEC”). Investments in these associatedorganizations are accounted for using the cost method of accounting because theCompany’s investment is less than 20% of the total equity capital of eitherorganization.  CFC and TEC capitalallocations

 

F-9

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are determined annually by the respective organizations based on theirbylaws, operating margins and other factors. The Company recognizes equityallocations, and income, from the associated organizations when declared by theorganizations. For the year ended December 31, 2002, nine months ended December31, 2001, and the year ended March 31, 2001, allocation of income fromassociated organizations was $478,000, $1,205,000 and $823,000, respectively.CFC is the Company’s primary lender and TEC provides various lobby services forelectric cooperatives in Texas.

 

**Investments and Notes Receivable**

 

The Company normally accounts for itsinvestments under the cost basis method of accounting if the investment is lessthan 20% of the voting stock of the investee, or under the equity method ofaccounting if the investment is greater than 20% of the voting stock of  the investee.

 

The Company previously had investments in oiland gas royalty interests.  As discussedin Note 9, effective December 1, 2000, the Company transferred its oil and gasroyalty interests in exchange for shares of common stock of Map Resources, Inc.(“MAP”). Since December 1, 2000, the Company has accounted for its investmentin MAP under the equity method of accounting.

 

**Utility Plant**

 

Utility plant is stated at the original costof construction, including the cost of contracted services, direct labor,materials and similar overhead items. The cost of maintenance, repairs and minor replacements are charged tooperations as incurred.  Gains or lossesresulting from retirements or other dispositions of utility property in thenormal course of business are credited or charged to the accumulated provisionfor depreciation.  The Company does notaccrue any cost for major maintenance or repair projects.

 

Contributions in aid of construction are creditedto the applicable utility plant accounts.

 

Depreciation is provided on a straight linebasis over estimated useful lives of the assets as follows:

 
| Transmission plant         |   | 10 - 33 years |   |
|----------------------------|--------|---------------|--------|
| Distribution plant         |   | 32 years      |   |
| General plant:             |   |          |   |
| Structure and improvements |   | 40 years      |   |
| Transportation             |   | 6 - 8 years   |   |
| Computer equipment         |   | 5 - 7 years   |   |
| Other                      |   | 16 - 21 years |   |

 

**Nonutility Property**

 

Nonutility property is stated at originalcost. Maintenance, repairs and miscellaneous replacement and renewals of nonutilityproperty are charged to operations as incurred. The majority of depreciation isprovided on a straight line basis over estimated useful lives, which range from15 to 30 years.

 

Income and expenses related to the Company’sprimary real estate property are recognized on an accrual basis. Income fromthe Company’s miscellaneous real estate partnership investments is recognizedas income is received. Income recorded for each period shown has been $12,000or less.

 

**Goodwill and Intangible Assets**

 

Prior to the implementation of SFAS No. 142,“Goodwill and Other Intangible Assets,” amortization of goodwill was computedon a straight-line basis over a 60-month period.  The Company adopted SFAS No. 142 beginning January 2002 andtherefore assessed its goodwill for impairment at that date, and atDecember 31, 2002.  In accordancewith this pronouncement, the Company reviews its goodwill and intangible assetswith indefinite lives on an annual basis and makes a determination as towhether an impairment has occurred.  Inreviewing goodwill, management compares the imputed fair value of the goodwillto its recorded carrying value. Evaluation of fair value takes into

 

F-10

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consideration various factors such as number of meters, economic growthof a geographical area, diversity in the customer base and power suppliers andtheir mix of fuel costs.  No impairmenthas been necessary because the fair value of goodwill exceeded the carryingvalue.

 

Separate intangible assets that are notdeemed to have indefinite lives will continue to be amortized over theirestimated useful lives, which range from 3 to 10 years.

 

**Deferred Revenue**

 

Deferred revenues are included in Deferredcredits on the balance sheet (see Note 20), and represent power costs expensedin prior periods that will be billed to customers and recognized as revenueover the next 12 months.

 

**Capitalized Interest**

 

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

 

**Equities and Margins**

 

The Cooperative’s equities and marginsconsisted of patronage capital credits, patronage capital obligated to beconverted into shareholder equity, and other equities and margin accounts forthe periods before the conversion. According to the Cooperative’s Bylaws, onlythe Cooperative’s operating profits could be allocated to the members’ equityaccounts. Operating losses and nonoperating gains and losses were recorded asother equities and margins and not allocated to members’ equity accounts.Subsidiary gains and losses were recorded as other equities and margins.

 

For the nine months ended December 31, 2001,and the year ended March 31, 2001, in accordance with the Cooperative’s conversionplan, the Cooperative repurchased certain members’ equity account balancesaggregating approximately $2,181,000 and $621,000, respectively, at adiscounted cash price of $1,524,000 and $402,000, respectively. The differencewas credited to the Cooperative’s other equity accounts. As of December 31,2001, the equity retirement payable had been fully paid. As of March 31, 2001,the Cooperative’s equity retirement payable balance was $411,000.  As of December 31, 2001, $12,390,000 wasreclassified from Patronage Capital to Patronage Capital Obligated to beConverted into Shareholder Equity, with the subsequent issuance of theSuccessor’s common stock in the first quarter of 2002.

 

For the nine months ended December 31, 2001,and the year ended March 31, 2001, in accordance with the Cooperative’sconversion plan, the Cooperative repurchased certain members’ patronage capitalcredit balances aggregating $909,000 and $2,401,000, respectively, by issuingelectric credits of the same respective amounts to be ratably applied to themembers’ electric bills over a 24-month period. As of December 31, 2002 and2001, the balance of the equity redemption credits was $732,000 and $1,195,000,respectively.

 

**Revenue Recognition**

 

For all periods through theend of 2002, the Company and its predecessor, the Cooperative, utilized thecycle billing method to recognize revenue, pursuant to the rate-making policyas set by the Board of Directors.  Thecycle billing method recognizes revenue on an “as billed basis” which recognizesrevenue when the customer is billed and not on an accrual basis, whichrecognizes revenue as the power is distributed to the customer.  Had the Company/Cooperative recorded anaccrual, a regulatory liability would have existed because the entities were notentitled to recognize revenue until the customers had been billed.  In the utility industry, the rate-makingpolicy defines the accounting requirements according to SFAS No. 71.

 

Effective January 1, 2003,the Company’s Board of Directors changed the rate-making policy to recognizeunbilled revenue.  At such time, theCompany will be required to change accounting principles in order to properly

 

F-11

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recognize revenue.  Under the new rate-making structure, the Company will accruerevenue and recognize revenue when power is distributed to the customer.

 

Unrecognized, unbilled electric revenues asof December 31, 2002 and 2001, were approximately $2,521,000 and $2,076,000.

 

Late-payment fees are accrued into incomeafter the passage of the due-date for customers. Only the current month’sbilled revenue is subjected to a one-time 5% late-payment penalty.

 

Revenues from gas sales and royalty incomewere accrued monthly based on estimated sales. Other revenue consists primarilyof building rental income and is accrued monthly based on contractual leaseobligations.

 

**Purchased Power Costs**

 

The Company accrues its purchased power costbased on actual usage through the end of each month.

 

The Company’s tariffs for electric serviceinclude power cost recovery clauses under which electric rates charged tocustomers are adjusted to reflect actual power costs incurred. In September2001, the Company determined that approximately $1,700,000 of collected powerrecovery costs subject to refund represented billable costs incurred and as aresult, recorded an adjustment to reduce purchased power costs and thepurchased power subject to refund account. This amount was reflected in thepower recovery costs subject to refund liability.  January 2002, the Company determined that approximately$4,360,000 inclusive of the $1,700,000 described above, of power costs incurredand expensed in periods prior to 2002 were recoverable costs.  These costs were approved by the Board to berecovered through billings to customers over a 24 month period beginning inJanuary of 2002 and ending in December 2003. See Note 20.  As of December31, 2002, the Company’s purchased power cost subject to recovery was$3,501,000, and at December 31, 2001, purchased power subject to refund was$387,000.

 

**Stock Based Compensation**

 

The Company accounts for its employee stockincentive plan using the intrinsic method in accordance with AccountingPrinciples Board Opinion No. 25, "Accounting for Stock Issued to Employees,and as amended by SFAS No. 123, "Accounting for Stock-BasedCompensation."  If compensationcost had been determined in accordance with SFAS No. 123, the Company'snet income and earnings per share on a pro-forma basis for 2002 would not havebeen different from the Company's reported results of operations or earningsper share.  See also Note 19.

 

**Federal Income Taxes**

 

The Company accounts for federal income taxesunder the asset and liability method of accounting for income taxes.  Under this method, deferred income taxes arerecognized for the estimated future tax consequences of “temporary differences”by applying enacted statutory tax rates for each taxable jurisdictionapplicable to future years to differences between the financial statement carryingamounts and the tax basis of existing assets and liabilities.  The Company records a valuation allowance toreduce its deferred tax assets to the extent it is more likely than not thatsuch deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in taxrate is recognized in income in the period that includes the enactment date.

 

The Cooperative and NewCorp are tax-exemptorganizations under Internal Revenue Code Section 501(c)(12). Energy andCapstar are taxable organizations for Internal Revenue Service purposes andfile a consolidated federal income tax return. CRCFC is a taxable organization for Internal Revenue Service purposesand files a separate federal income tax return.  For the nine months ended December 31, 2001, and the year endedMarch 31, 2000, Energy, Capstar and New West incurred no tax liability.

 

Upon conversion to a shareholder ownedbusiness corporation, the activities and transactions formerly performed by theCooperative became taxable. The pro forma results of the Cooperative, assumingit was taxable, would not have been materially different, due to net operatingloss carryforwards available to reduce tax expense for the nine months endedDecember 31, 2001, and year ended March 31, 2001. 

 

F-12

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**Derivative Instruments**

 

The Company uses derivative instruments tomanage the natural gas component of power costs, which minimizes thefluctuations in customers’ power bills. All payments made or received in connection with these type oftransactions will be collected from or rebated to the customers through thepower cost recovery component of the customers’ power bills.  The fair market value of these instrumentsis recorded as an asset or liability with a corresponding regulatory liabilityor regulatory asset, as all amounts paid or received will be passed through tothe Company’s customers.

 

**NewAccounting Standards**

 

On August 15, 2001, the FASBissued SFAS No. 143, “Asset Retirement Obligations.” SFAS No. 143addresses the financial accounting and reporting for obligations associatedwith the retirement of tangible long-lived assets and the associated assetretirement costs. SFAS No. 143 is required to be adopted for fiscal yearsbeginning after June 14, 2002. The Company anticipates that the adoptionof SFAS No. 143 will not have an effect on its results of operations orfinancial position.

 

In July 2002, the FASBissued SFAS No. 146, “Accounting for Costs Associated with Exit or DisposalActivities.” SFAS No. 146 requires that a liability for costs associatedwith an exit or disposal activity be recognized and measured initially at fairvalue only when the liability is incurred. SFAS No. 146 is effective forexit or disposal activities that are initiated after December 31, 2002.The Company anticipates that the adoption of SFAS No. 146 will not have asignificant effect on its results of operations or financial position.

 

In November 2002, the FASBissued FASB Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, including Indirect Guarantees of Indebtedness ofOthers” (“FIN 45”). FIN 45 requires a guarantor to recognize a liability, atthe inception of the guarantee, for the fair value of obligations it hasundertaken in issuing the guarantee and also include more detailed disclosureswith respect to guarantees. FIN 45 is effective for guarantees issued ormodified after December 31, 2002, and requires the additional disclosuresfor interim or annual periods ended after December 15, 2002. The Companydoes not expect that the provisions of FIN 45 will have a material impact onits results of operations or financial position.

 

In January 2003, the FASBissued FASB Interpretation No.46, “Consolidation of Variable Interest Entities— an interpretation of ARB No. 51” (“FIN 46”). FIN 46 requires that if anentity has a controlling financial interest in a variable interest entity, theassets, liabilities and results of activities of the variable interest entity shouldbe included in the consolidated financial statements of the entity. FIN 46provisions are effective immediately for all arrangements entered into afterJanuary 31, 2003. For those arrangements entered into prior toJanuary 31, 2003, the FIN 46 provisions are required to be adopted at thebeginning of the first interim or annual period beginning after June 15,2003. The Company does not expect that the provisions of FIN 46 will have amaterial impact on the Company’s results of operations or financial position.

 

In December, 2002, the FASBissued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition andDisclosure” (SFAS No. 148), an amendment of FASB Statement No. 123.  SFAS No. 148 provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No.123 to require prominent disclosures in both annual and interim financialstatements about the method of accounting for stock-based employee compensationand the effect of the method used on reported results.  The Company utilizes the intrinsicmethod.  The Company believes that SFASNo. 148 will have no impact on its results of operations or financial position.

 

F-13

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**Other Comprehensive Income**

 

There were no items of comprehensive incomefor any period presented. 

 

**Reclassifications**

 

Certain reclassifications have been made toprior periods’ financial statements to conform to the presentation adopted inthe current period.

 

**2. CORPORATE RESTRUCTURING**

 

On October 20, 1998, the Cooperative’smembers adopted a conversion plan to reorganize the Cooperative from a memberowned electric cooperative to a shareholder owned business corporation. Theconversion plan granted broad powers to the Cooperative’s Board of Directors,without further action of the membership, to engage in all transactionsnecessary to implement the conversion plan. Such powers include, among otherthings, the ability to form and capitalize new entities, transfer and/or sellassets, and purchase interests of the members and holders of Cooperative’sequity accounts.

 

In connection with the conversion plan, CapRock Energy Corporation was formed in December 1998 as a subsidiary of theCooperative and substantially all of the Cooperative’s operational activitieswere transferred to Energy. Under the conversion plan, the Cooperative was tocontinue in existence and was to continue to provide electricity to its membersuntil such time as the Board of Directors, at its option and without furtherapproval or action of its members, elected to take one of the actionsauthorized therein. The Board elected to transfer all of the assets and liabilitiesto Energy, in exchange for common stock of Energy, to distribute such stock tothe Cooperative’s members and holders of equity accounts and ultimately toliquidate and dissolve the Cooperative.

 

Energy has registered shares of its commonstock with the Securities and Exchange Commission as of February 8, 2002, andthey were distributed to the Cooperative’s members and holders of equityaccounts that chose that option. On March 14, 2002, the common stock of Energywas approved for listing on the American Stock Exchange. See Note 16 concerningthe Company’s repurchase offer.

 

Energy’s Articles of Incorporation providethat any shareholder or affiliate of a shareholder holding in excess of 5% ofEnergy’s outstanding common stock will have its voting rights for those sharesin excess of 5% reduced to 1/100 per share.

 

Pursuant to the conversion plan, during thenine months ended December 31, 2001, and the year ended March 31, 2001, theCooperative retired equity accounts aggregating $3,090,000 and $3,022,000,respectively, through the Cooperative’s conversion “Dutch Auction” process andits rescission offer.

 

All Cooperative members with equity accountsgreater than $10 received notices from the Cooperative regarding their equityaccount balances and the “Dutch auction” and electric credit process asoutlined in the conversion plan. All Dutch auction bids of 70% or less ofstated capital credit account balances received from members were accepted bythe Cooperative. For the nine months ended December 31, 2001, and the yearended March 31, 2001, equity accounts of $2,181,000 and $621,000, respectively,were retired for a discounted Dutch auction cash price of $1,524,000 and$402,000, respectively. The difference was credited to the Cooperative’s otherequity account. As of December 31, 2001, the equity retirement payable had beenfully paid. As of March 31, 2001, the Cooperative’s equity retirement payablebalance was $411,000. As of December 31, 2001, $12,390,000 was reclassifiedfrom Patronage Capital to Patronage Capital Obligated to be Converted toShareholder Equity, with the subsequent issuance of Energy common stock in thefirst quarter of 2002.

 

For the nine months ended December 31, 2001,and the year ended March 31, 2001, Cooperative members opting to receiveelectric credits equal to 100% of their equity account balances totaled$909,000 and $2,401,000 respectively. Equity redemption electric credits ofless than $240 were applied immediately and credits of over $240 are beingratably applied over a 24-month period to those former members’ electric bills.The unamortized balance of equity redemption credits as of December 31, 2002and 2001, was $732,000 and $1,195,000, respectively.

 

F-14

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**3. PRO-FORMA CONSOLIDATED FINANCIAL DATA (UNAUDITED)**

 

The unaudited pro-forma consolidated balancesheet as of December 31, 2001, shows the conversion of the Cooperative’sequities and margins converted into 1,302,355 shares of common stock of Energy.

 
|                                                                                                     |   | **(IN THOUSANDS)** |    |
|----------------------------------------------------------------------------------------------------------|--------|--------------------|---------|
|                                                                                                     |   | **HISTORICAL**     |    | **ADJUSTMENTS** |   | **PRO  FORMA** |   |
| ASSETS                                                                                                   |   |               |    |   |   |   |   |
| Current assets                                                                                           |   | $                  | 12,056  |   | $ | — |   | $ | 12,056 |   |
| Utility and nonutility  property                                                                         |   | 166,170            |    | — |   | 166,170 |   |
| Investments and notes  receivable                                                                        |   | 25,904             |    | — |   | 25,904 |   |
| Other assets                                                                                             |   | 10,329             |    | (1,570 | )(A) | 8,759 |   |
|                                                                                                     |   | $                  | 214,459 |   | $ | (1,570 | ) | $ | 212,889 |   |
| LIABILITIES AND EQUITIES                                                                                 |   |               |    |   |   |   |   |
| Current liabilities                                                                                      |   | $                  | 19,734  |   | — |   | $ | 19,734 |   |
| Long-term debt                                                                                           |   | 181,732            |    | — |   | 181,732 |   |
| Deferred credits                                                                                         |   | 5,321              |    | — |   | 5,321 |   |
| Equities and margins                                                                                     |   | 7,672              |    | (7,672 | )(B) | — |   |
| Shareholders’ equity:                                                                               |   |               |    |   |   |   |   |
| Common stock, $.01 par  value,   50,000,000 shares authorized,   1,302,355 shares issued and outstanding |   | —             |    | 13 | (B) | 13 |   |
| Additional paid in  capital                                                                              |   | —             |    | (1,570 | )(A) | 6,089 |   |
|                                                                                                     |   |               |    | 7,659 | (B) |   |   |
| Retained earnings                                                                                        |   | —             |    | — |   | — |   |
|                                                                                                     |   | $                  | 214,459 |   | $ | (1,570 | ) | $ | 212,889 |   |

 

The following are pro forma adjustments to the accompanying pro formaconsolidated financial data:

 

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(A)                  To reclassify deferred stockconversion costs to additional paid in capital.

(B)                    To record 1,302,355 shares of commonstock issued and to reclassify other equities and margins to shareholders’equity.

 

F-15

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

 

The following unaudited condensedconsolidated statements of operations are presented in addition to theconsolidated statements of operations in order to present comparable periods(in thousands):

 
|                                         |   | **YEAR ENDED  DECEMBER 31,  2001** |   | **NINE MONTHS  ENDED  DECEMBER 31,  2000** |   |
|----------------------------------------------|--------|------------------------------------|--------|--------------------------------------------|--------|
|                                         |   | **PREDECESSOR**                    |   | **PREDECESSOR**                            |   |
|                                         |   |                               |   |                                       |   |
| Total operating revenues                     |   | $                                  | 73,412 |                                       | $      | 52,100 |   |
|                                         |   |                               |   |                                       |   |
| Purchased power                              |   | 40,781                             |   | 32,379                                     |   |
| Operations and  maintenance                  |   | 7,427                              |   | 5,484                                      |   |
| General and  administrative                  |   | 4,664                              |   | 2,559                                      |   |
| Depreciation and  amortization               |   | 6,159                              |   | 4,340                                      |   |
| Property taxes                               |   | 1,380                              |   | 1,024                                      |   |
| Write off of investments                     |   | —                             |   | 3,878                                      |   |
| Other                                        |   | 310                                |   | 437                                        |   |
| Total operating expenses                     |   | 60,721                             |   | 50,101                                     |   |
| Operating income                             |   | 12,691                             |   | 1,999                                      |   |
|                                         |   |                               |   |                                       |   |
| Interest expense                             |   | (10,818                            | )      | (7,903                                     | )      |
| Other income items                           |   | 2,961                              |   | 1,019                                      |   |
| Net income (loss) before  extraordinary item |   | 4,834                              |   | (4,885                                     | )      |
| Extraordinary item                           |   | —                             |   | 969                                        |   |
|                                         |   |                               |   |                                       |   |
| Net income (loss)                            |   | $                                  | 4,834  |                                       | $      | (3,916 | ) |

 

**5. PROPOSED LAMAR ACQUISITION**

 

In October 1999, theCooperative entered into an agreement (“Combination Agreement”) with Lamar County Electric CooperativeAssociation (“Lamar”), pursuant to which Lamar was to combine with, and becomean operating division of, the Cooperative. The members of Lamar subsequently approved this Combination Agreement.  The agreement provided that if thecombination was terminated by Lamar, with certain specific allowableexceptions, Lamar was required to reimburse the Cooperative for all costs andexpenses it had incurred, whether paid to outside parties or incurredinternally, with respect to the combination.

 

The completion of thecombination was delayed because of litigation with Lamar’s power supplier. Thepower supplier claimed that  Lamar andthe Cooperative  had each breachedvarious agreements.

 

On August 29, 2000, theCooperative and Lamar entered into a five year Management ServiceAgreement.  Under the terms of thatagreement, Lamar’s Board of Directors continued to set policy and perform allof its fiduciary responsibilities, and the Cooperative performed certain managementservices for Lamar.  As compensation forits management services, the Cooperative (subsequently the Company) received$1,000 per month plus reimbursed costs and expenses.  One of the terms of the agreement provided that if Lamarterminated the agreement prior to the expiration of the original term, Lamarwould be required to pay a cancellation fee of $300,000 as liquidated damages.

 

F-16

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Lamar terminated theCombination Agreement in October 2002 and the Management Service Agreement inNovember 2002.  The Company believesthat Lamar’s stated reason for termination of the Combination Agreement doesnot fall within the specific allowable exceptions set forth in the agreement,and therefore the Company believes it is entitled to reimbursement of all costsand expenses incurred.  The Company isalso seeking the specified liquidated damages fee of $300,000 in connectionwith the termination of the Management Service Agreement.

 

Because Lamar terminated theCombination Agreement, generally accepted accounting principles required theimpairment of costs previously capitalized that were incurred in connectionwith the combination.  At December 31,2002, these costs, mainly outside legal and consulting fees, aggregated$1,357,000 have been expensed and are shown on the consolidated statement ofoperations.  At December 31, 2001, thesecosts aggregated approximately $956,000 and are shown on the consolidatedbalance sheet in Other assets.  See Note12.

 

**6. PROPOSED CITIZENS ACQUISITION**

 

In February 2000, the Cooperative andCitizens Communications Company, formerly Citizens Utilities Company(“Citizens”), a publicly-owned utility corporation, entered into Purchase andSale Agreements (the “Agreements”) for Citizens’ electric utility businesses inArizona and Vermont for a total of $287 million.

 

Although the Cooperative was able to obtain afinancing commitment for approximately $191 million for the Arizonaacquisition, it was unable to secure financing on acceptable terms andconditions for the balance of the purchase price due in large part to theunprecedented increase in Arizona’s wholesale power costs and the inability torecover such increased costs quickly from ratepayers.

 

On March 7, 2001, the Cooperative andCitizens agreed to terminate the Agreements and the Cooperative wrote off$2,815,000 of deferred acquisition costs related to the terminated Citizensacquisition, including termination costs of $1,100,000.

 

**7. PROPOSED MDC ACQUISITION**

 

In February 2000, the Cooperative executed anagreement to acquire all of the stock of Multimedia Development Corporation(“MDC”), a wireless telecommunication entity with operations in New Mexico, for$12,500,000, subject to certain working capital adjustments.

 

Although the Cooperative was successful insecuring financing for part of the purchase price, it was unable to secureadequate financing for the acquisition on acceptable terms and conditions.Accordingly, for the year ended March 31, 2001, the Cooperative wrote off$1,063,000 related to the terminated MDC acquisition.

 

**8. OTHER CURRENT ASSETS**

 

Other current assets as of December 31, 2002and 2001, consisted of the following (in thousands):

 
|                                  |   | **DECEMBER 31,** |   |
|---------------------------------------|--------|------------------|--------|
|                                  |   | **2002**         |   | **2001** |   |
|                                  |   |             |   |   |   |
| Capital lease sinking fund (Note  14) |   | $                | 7,395  |   | $ | — |   |
| Derivative contracts at market  value |   | —           |   | 898 |   |
| Prepaid insurance                     |   | 335              |   | 219 |   |
| Interest receivable                   |   | 58               |   | 31 |   |
| Other                                 |   | 17               |   | 271 |   |
| Total Other current assets            |   | $                | 7,805  |   | $ | 1,419 |   |

 

F-17

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At December 31, 2002, the capital leasesinking fund balance of $7,395,000 is shown in Other current assets because thefinal balloon payment associated with the capital lease for the transmissionsystem is due in 2003.  At December 31,2001, the balance of the capital lease sinking fund was $6,189,000 and wasshown in Other assets.

 

**9. INVESTMENTS AND NOTES RECEIVABLE**

 

Investments and notes receivable as ofDecember 31, 2002 and 2001, consisted of the following (in thousands):

 
|                                                                 |   | **DECEMBER 31,** |   |
|----------------------------------------------------------------------|--------|------------------|--------|
|                                                                 |   | **2002**         |   | **2001** |   |
|                                                                 |   |             |   |   |   |
| Investments in  associated organizations:                            |   |             |   |   |   |
| CFC capital term  certificates                                       |   | $                | 6,304  |   | $ | 6,393 |   |
| CFC patronage capital                                                |   | 2,519            |   | 2,522 |   |
| TEC patronage capital  and bonds                                     |   | 852              |   | 817 |   |
| Other                                                                |   | 73               |   | 136 |   |
| Total investments in  associated organizations                       |   | 9,748            |   | 9,868 |   |
|                                                                 |   |             |   |   |   |
| Investment in United  Fuel (Note 15)                                 |   | 360              |   | 360 |   |
| Notes receivable—United  Fuel, net of current portion (Note 15) |   | —           |   | 12,667 |   |
| Investment in MAP                                                    |   | 2,162            |   | 2,047 |   |
| Other investments                                                    |   | 220              |   | 962 |   |
| Total Investments and  notes receivable                              |   | $                | 12,490 |   | $ | 25,904 |   |

 

The Company previously had investments in oiland gas royalty interests. As discussed in Note 24 to the consolidatedfinancial statements, as of December 1, 2000, the Company transferred all ofits oil and gas royalty interests with a net book value of $3,531,000 to MAP, anewly formed company, in exchange for 3,675,000 shares (100%) of MAP’s commonstock and a $1,500,000 note receivable. As of December 31, 2000, MAP issued anadditional 3,675,000 shares of common stock to Flagstone Petroleum Corporation,a privately owned company, in exchange for oil and gas interests and otherproperties with an estimated fair market value of $1,553,000. Accordingly, asof March 31, 2001, the Company owned approximately 49% of MAP, with suchinterest being reduced to 42% at December 31, 2001, upon the exercise ofcertain stock options and issuance of additional stock. The investment in MAPis accounted for using the equity method of accounting. The Company’s equityearnings in MAP for the year ended December 31, 2002, and the nine months endedDecember 31, 2001, was $115,000 and $88,000, respectively, and $127,000 for thefour months ended March 31, 2001.

 

F-18

----

 

**10. UTILITY PLANT**

 

Utility plant as of December 31, 2002 and 2001,consisted of the following (in thousands):

 
|                                 |   | **DECEMBER 31,** |    |
|--------------------------------------|--------|------------------|---------|
|                                 |   | **2002**         |    | **2001** |   |
|                                 |   |             |    |   |   |
| Transmission facilities              |   | $                | 64,757  |   | $ | 59,824 |   |
| Distribution facilities              |   | 177,892          |    | 175,355 |   |
| General facilities                   |   | 10,097           |    | 12,458 |   |
| Total Utility plant                  |   | 252,746          |    | 247,637 |   |
| Less accumulated  depreciation       |   | (95,648          | )       | (85,562 | ) |
| Total utility plant in  service, net |   | 157,098          |    | 162,075 |   |
| Construction work in  progress       |   | 225              |    | 2,472 |   |
| Total Utility plant, net             |   | $                | 157,323 |   | $ | 164,547 |   |

 

All utility plant assets are pledged to securedebt and capital lease obligations.

 

As discussed in Note 14, the Company hasreceived various proposals to either refinance the debt associated with thetransmission system or sell the transmission system. At December 31, 2002, thetransmission system had a net book value of approximately $24,450,000. Anyproposed transaction will be subject to several conditions, including:

 

Approval of the transaction by the Board ofDirectors and appropriate individuals of the buyer;

•                                          Completion of any due diligencereviews;

•                                          Execution by the parties of adefinitive agreement and all other necessary agreements; and

•                                          Approval of regulatory agencieshaving jurisdiction over the transmission system, if applicable or necessary.

 

Upon closing, all amounts remaining unpaidwith respect to the transmission capital lease obligation will be deducted fromthe proceeds of any sale.

 

**11. NONUTILITY PROPERTY**

 

Nonutility property as of December 31, 2002and 2001, consisted of the following (in thousands):

 
|                            |   | **DECEMBER 31,** |   |
|---------------------------------|--------|------------------|--------|
|                            |   | **2002**         |   | **2001** |   |
|                            |   |             |   |   |   |
| Real estate                     |   | $                | 2,257  |   | $ | 2,257 |   |
| Furniture, fixtures, and  other |   | 7                |   | 11 |   |
| Total Nonutility  property      |   | 2,264            |   | 2,268 |   |
| Less accumulated  depreciation  |   | (700             | )      | (645 | ) |
| Total Nonutility,  property net |   | $                | 1,564  |   | $ | 1,623 |   |

 

The Company owns a 50,000 square foot officebuilding that is used as its general corporate headquarters. The Companycurrently occupies approximately 30% of the building and the remainder isleased to commercial tenants, subject to leasing terms ranging from monthly to5 years. For the year ended December 31, 2002, nine months ended December 31,2001 and the year ended March 31, 2001, third party building rental revenue was$286,000, $244,000 and $253,000 respectively. Building rental revenues, whichare not material to the Company’s operations, for each of the next

 

F-19

----

 

five years are expected to be approximately $250,000 per year. As ofDecember 31, 2002 and 2001, the net book value of the building and relatedproperty was $1,161,000 and $1,219,000, respectively.

 

The Company has guaranteed debt of certainreal estate partnerships, with the maximum exposure of such guaranteesaggregating  $273,000 at December 31,2002.  The guarantees are over the lifeof the associated debt of the partnership, and, if called, would requirepayment by the Company.

 

**12. OTHER ASSETS**

 

Other assets as of December 31, 2002 and2001, consisted of the following (in thousands):

 
|                                                           |   | **DECEMBER 31,** |   |
|----------------------------------------------------------------|--------|------------------|--------|
|                                                           |   | **2002**         |   | **2001** |   |
| Capital lease sinking  fund (Note 14)                          |   | $                | — |   | $ | 6,189 |   |
| Capital lease  acquisition cost, net of amortization (Note 14) |   | 735              |   | 1,035 |   |
| McCulloch goodwill, net  of amortization                       |   | 199              |   | 199 |   |
| Lamar acquisition costs  (Note 5)                              |   | —           |   | 956 |   |
| Stock conversion costs                                         |   | —           |   | 1,570 |   |
| Other                                                          |   | 228              |   | 380 |   |
| Total Other assets                                             |   | $                | 1,162  |   | $ | 10,329 |   |

 

The stock conversion costs are the directcosts associated with the conversion of the Cooperative into a shareholderowned corporation. These amounts were charged against equity as a reduction toadditional paid in capital when the conversion occurred in February 2002.

 

At December 31, 2002, the capital leasesinking fund is shown in Other current assets because the associated capitallease for the transmission system is due in 2003.

 

The McCulloch goodwill represents costsincurred in connection with the acquisition of another electric cooperative in1999, in the amount of $373,000.  As ofDecember 31, 2002 and 2001, the accumulated amortization was $174,000.

 

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

 

The CFC notes have been issued in conjunctionwith a Second Restated Mortgage and Security Agreement, dated October 24, 1995(“Loan Agreement”).  Substantially allof the Company’s distribution assets are collateralized in connection with thenotes. The notes have maturity dates ranging from 2005 to 2035, with requiredquarterly payments of principal and interest. Under the Loan Agreement, the Company may elect to pay interest on afixed or variable interest rate basis, as defined. The existing long-term debtconsists of series of loans from CFC that impose various restrictive covenants,including, among other things, provisions that prohibit the incurrence orguaranty of other secured indebtedness and requires the maintenance of a 1.35debt 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 20%.

 

In conjunction with the conversion plan, CFCwaived the 20% equity to total assets ratio requirement, consented to thedistribution of cash and electric credits to former members, waived the 1.35debt service coverage ratio requirement, and notified the Company that allexisting CFC indebtedness may remain in place with CFC after the conversionfrom a member owned cooperative to a shareholder owned corporation.

 

In December 2002, the Company elected toconvert the interest rates on the majority of the mortgage notes from variableto fixed.  These lock-ins of interestrates were done for one, two and three year periods.  Substantially all of the

 

F-20

----

 

CFC fixed rate notes are subject to interest rate repricing at the endof various periods, at the Company’s option. Mortgage notes with CFC as of December 31, 2002 and 2001 consisted ofthe following (in thousands):

 
|                                                        |   | **DECEMBER 31,** |    |
|-------------------------------------------------------------|--------|------------------|---------|
|                                                        |   | **2002**         |    | **2001** |   |
| Interest at 3.35% with  interest repricing in December 2003 |   | $                | 11,525  |   | $ | — |   |
| Interest at 4.20% with  interest repricing in December 2004 |   | 70,519           |    | — |   |
| Interest at 4.70% with  interest repricing in December 2005 |   | 35,189           |    | — |   |
| Interest at fixed rates:                                    |   |             |    |   |   |
| 6.50%                                                       |   | 6,188            |    | — |   |
| 7.00%                                                       |   | 3                |    | — |   |
| 5.79%  weighted average                                |   | —           |    | 13,323 |   |
| Interest at variable  rate of 3.95%                         |   | —           |    | 113,135 |   |
| Interest at variable  rate of 3.65%                         |   | 28,000           |    | — |   |
|                                                        |   | 151,424          |    | 126,458 |   |
| less current maturities                                     |   | (3,680           | )       | (3,044 | ) |
| Total mortgage debt, net  of current portion                |   | $                | 147,744 |   | $ | 123,414 |   |

 

As of December 31, 2001, the Company had aSecured Revolving Line of Credit Agreement with CFC aggregating $28 million,interest payable at CFC prime rate plus 1%, secured by distribution plantassets and renewable annually.  As ofDecember 31, 2001, the outstanding balance of the line of credit was$28,000,000 with an interest rate of 5.1%. In October 2002, CFC agreed to convert the $28 million line of credit toa long term mortgage note with quarterly payments of approximately $233,000based on a 30 year amortization schedule, a final balloon payment in 5 yearsand deferral of the initial principal payment for one year from the date ofclosing, which date has not yet been determined.  At December 31, 2002, the average interest rate was 3.9%, withinterest payments due quarterly.  Thenew financing arrangements are subject to execution of the new loan documents.

 

As of March 31, 2000, the long-term debtassumed as a part of the McCulloch acquisition had a weighted average interestrate of 4.24%. On May 16, 2000, substantially all of that long-term debt wasrefinanced resulting in an extraordinary gain from early extinguishment of debtof approximately $969,000 for the year ended March 31, 2001. These loans werepaid off with loan proceeds received from CFC.

 

The Company has capitalized, as a part ofutility plant, the cost of borrowed funds used for financing construction.Capitalized interest for the year ended December 31, 2002, the nine monthsended December 31, 2001 and the year ended March 31, 2001, was $12,000, $31,000and $131,000, respectively. The rate used for interest charged to constructionis a variable rate equal to the rate on the short-term line of credit with CFC.

 

Annual maturities of the mortgage notes as ofDecember 31, 2002, are as follows (in thousands):

 
| 2003                |   | $       | 3,680   |   |
|---------------------|--------|---------|---------|--------|
| 2004                |   | 4,731   |    |
| 2005                |   | 8,295   |    |
| 2006                |   | 4,553   |    |
| 2007                |   | 28,961  |    |
| Thereafter          |   | 101,204 |    |
|                |   |    |    |
| Total mortgage debt |   | $       | 151,424 |   |

 

F-21

----

 

**14. CAPITAL LEASE - TRANSMISSION SYSTEM**

 

In connection with the financing,construction and utilization of its transmission line, the Company entered intoagreements with Southwestern Public Service Company (“SPS”), Metropolitan LifeInsurance Company (“Met Life”), and John Hancock Leasing Corporation (“John Hancock”).The John Hancock lease was paid in full during the year ended March 31,2000.  The substance of the remainingagreements includes financing arrangements with Met Life and a powertransmission arrangement with SPS. These agreements qualify as capital leaseswith reversionary features and, as a result, the transmission line, substationassets and associated capital lease obligations are reflected in the Company’sconsolidated financial statements.

 

The original cost related to the transmissionfacility and cost of the ten year capital lease of $59,000,000 and $2,999,000,respectively, are being recovered from customers through power cost billingsover a ten-year period. Consistent with this ratemaking treatment, thetransmission facilities and cost of capital lease are being amortized over tenyears. Principal payments on the transmission system capital lease obligationfor the year ended December 31, 2002, the nine months ended December 31, 2001,and the year ended March 31, 2001, were approximately $5,047,000, $3,577,000,and $4,490,000 respectively. The corresponding amortization of property andequipment under the capital lease was credited to accumulated depreciation andamortization accounts for the transmission facilities consistent with ratemakingtreatment.  Required principal paymentsof $17,632,000 for the capital lease obligation associated with thetransmission system as of December 31, 2002, are all classified as currentbecause the capital lease expires in September 2003.

 

Interest on the capital lease obligations forthe year ended December 31, 2002, nine months ended December 31, 2001, and theyear ended March 31, 2001, was approximately $1,443,000, $1,305,000 and$2,020,000, respectively, and is  classifiedas purchased power cost consistent with ratemaking treatment.

 

The lease payments include an amount for asinking fund, which will be used to reduce the amount of the final debtpayment. As of December 31, 2002 and 2001, the balance of the sinking fund was$7,395,000 and $6,189,000, respectively. See Notes 8 and 12.

 

The Company has received proposals to eitherrefinance the debt associated with the transmission system or sell thetransmission system. At December 31, 2002, the transmission system had a netbook value of approximately $24,450,000. This proposed transaction will be subject to several conditions,including:

 

•                                          Approval of the transaction by theBoard of Directors and appropriate individuals of the buyer;

•                                          Completion of any due diligencereviews;

•                                          Execution by the parties of adefinitive agreement and all other necessary agreements; and

•                                          Approval of regulatory agencieshaving jurisdiction over the transmission system, if applicable or necessary.

 

Upon closing, all amounts remaining unpaidwith respect to the transmission capital lease obligation will be deducted fromthe proceeds of any sale.

 

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

 

As of March 31, 2000, the Cooperative agreedto make loans totaling $15 million to two fuel and lubricant subsidiaries ofUnited Fuel and Energy Corporation (“United Fuel”). On July 12, 2000, theCooperative entered into and guaranteed, with CFC’s permission, a $15 million, three-year loanagreement with a bank. At December 31, 2002, the bank loan balance was$12,490,000 and is shown entirely in Current portion of long-term debt becauseit is due in 2003.  At December 31,2001, the loan balance was $13,667,000, and is included on the balance sheet inOther notes payable, net of the $1,000,000 current portion. The loan agreementrequires monthly payments based on a fifteen-year amortization with interest atWall Street Journal prime rate plus 1%, with such rates aggregating 5.25% and5.75% at December 31, 2002 and 2001, respectively.

 

F-22

----

 

Simultaneously, the Cooperative loaned $15million to United Fuel’s two subsidiaries with terms and conditionssubstantially identical to the bank loan agreement, interest at Wall StreetJournal prime rate plus 1.25%, and secured by United Fuel’s stock and properties,as well as plant and equipment of the United Fuel subsidiaries. The Cooperativehas pledged its security as collateral for its bank loan agreement. At December31, 2002, the United Fuel note receivable balance was $12,490,000, and is shownentirely in Current portion of notes receivable because it is due in 2003.  At December 31, 2001, the note receivablebalance was $13,667,000, and is included on the balance sheet in Investmentsand notes receivable, net of the $1,000,000 current portion. See also Note 9.At closing, the Cooperative acquired a 10% interest in United Fuel for$300,000, at a cost of $3,000 per share. In January 2001, the Cooperativeacquired an additional 5% net interest in United Fuel from certain sellingUnited Fuel shareholders for $60,000, at a cost of $1,200 per share. Inaddition, beginning January 1, 2002, as long as United Fuel is indebted to theCompany or until January 1, 2010, whichever is earlier, the Company has a rightto acquire an additional 10% ownership in United Fuel, exercisable in annualincrements of 1%-2% through January 1, 2010 at a price of $1,250 per share,subject to certain adjustments.  TheCompany accounts for its investment in United Fuel using the cost method of accounting.If the Company’s ownership in United Fuel were to exceed 20%, it would berequired to use the equity method of accounting.

 

The Company has current maturities oflong-term debt and capital leases of $33,924,000 due in 2003.  The Company believes that its cash flow fromoperations in 2003, cash on hand, including sinking fund balances, and fundsprovided by the repayment of the United Fuel note receivable will be more thansufficient to fund its 2003 debt repayment obligations.  United Fuel is currently in discussions withlenders in order to obtain financing that would provide funds to allow UnitedFuel to fully repay the Company’s note receivable.  If United Fuel is not successful in obtaining financing, theCompany has other options available to obtain the funds necessary to satisfy itsdebt obligations.  Also, in the eventUnited Fuel is not successful in obtaining financing, United Fuel, or itsshareholders who have provided the Company with personal guarantees of the notereceivable, would pay down the note and provide funds to the Company such thatthe Company would, together with its cash flow from operations, be able tosatisfy its debt obligations as they become due in 2003.  The Company is also considering, as analternative, an opportunity to extend the payment date of the note payable tothe bank for $12,490,000 for an additional year.

 

The Company has other miscellaneous capitalleases for certain equipment used in operations.  Future minimum lease payments are as follows (in thousands):

 
| 2003                             |   | $       | 122,000 |   |
|----------------------------------|--------|---------|---------|--------|
| 2004                             |   | 123,000 |    |
| 2005                             |   | 111,000 |    |
| 2006                             |   | 44,000  |    |
| 2007                             |   | 30,000  |    |
| Total capital lease  obligations |   | $       | 430,000 |   |

 

**16. REPURCHASE OFFER**

 

Commencing one year from the date of thedistribution of the Company's common stock to the former members of theCooperative in connection with the conversion plan and ending 60 daysthereafter, the Company offered to purchase at a price of $10 per share all ofits shares of common stock that were distributed in connection with thePlan.  The effect of the common stockpurchase commitment is unknown because it is based on the number ofshareholders who accept the offer. Shares of the Company's common stock were originally distributed tocertain former members of the Cooperative who elected to receive shares ofstock as payment for their equity and membership interest in theCooperative.  Pursuant to the terms ofthe conversion plan, the Company made a commitment to purchase those shares,held continuously by the original owners of record until the first anniversaryof the distribution of the shares at a price of $10 per share if the Companyhad sufficient cash available to purchase all shares tendered.  As of March 28, 2003, the currentmarket price is greater than the $10 offering price.

 

On February 5, 2003, the Company filedSchedule TO with the Securities and Exchange Commission, thus commencing therepurchase period, which is set to expire April 30, 2003.  In an effort to be inclusive rather thanexclusive, the Company made the offer to all shareholders of the Company.  The number of shares ultimately accepted bythe Company for repurchase will be determined by cash available.  If cash is not available, the Company canterminate the offer and return all shares tendered.  Because the terms and parameters of the repurchase offer wererevised, all amounts originally ascribed have been classified as Paid-incapital.  As of March 28, 2003, therewere 59,000 shares of common stock that had been tendered pursuant to theCompany’s repurchase offer.

 

F-23

----

 

**17. FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

The following table presents the carryingamounts and estimated fair values of the Company’s financial instruments atDecember 31, 2002 and 2001.  SFAS No.107 defines the fair value of a financial instrument as the amount at which theinstrument could be exchanged in a current transaction between willing parties.

 
|                      |   | **DECEMBER 31, 2002** |   | **DECEMBER 31, 2001** |   |
|---------------------------|--------|-----------------------|--------|-----------------------|--------|
|                      |   | **BOOK  VALUE**       |   | **FAIR  VALUE**       |   | **BOOK  VALUE** |   | **FAIR  VALUE** |   |
| Cash and cash equivalents |   | $                     | 9,899  |                  | $      | 9,899 |   | $ | 5,498 |   | $ | 5,498 |   |
| Mortgage notes            |   | 151,424               |   | 151,424               |   | 126,458 |   | 126,458 |   |
|                           |        |                       |        |                       |        |  |  |  |  |  |  |  |  |

 

The book value of cash and cash equivalentsapproximated fair value because of the short maturity of those instruments. Thecarrying values of accounts receivable and account payables included in theaccompanying consolidated balance sheets approximated market value at December31, 2002 and 2001. As described in Note 13, the Company has both fixed rate andvariable rate notes, but the fair value of the fixed rate mortgage notes areassumed to be the same as the carrying value because the interest rates arereflective of market rates.

 

**18. ACCRUED AND OTHER CURRENT LIABILITIES**

 

Accrued and other current liabilities atDecember 31, 2002 and 2001, consisted of the following (in thousands):

 
|                                             |   | **DECEMBER 31,** |   |
|--------------------------------------------------|--------|------------------|--------|
|                                             |   | **2002**         |   | **2001** |   |
| Accrued taxes                                    |   | $                | 227    |   | $ | 19 |   |
| Accrued interest                                 |   | 479              |   | 518 |   |
| Accrued payroll and employee  benefits (Note 19) |   | 1,530            |   | 1,035 |   |
| Accrued other                                    |   | 66               |   | 156 |   |
| Derivative liabilities                           |   | —           |   | 898 |   |
| Customer deposits and prepayments                |   | 752              |   | 541 |   |
| Total Accrued and other current  liabilities     |   | $                | 3,054  |   | $ | 3,167 |   |

 

**19. EMPLOYEE BENEFIT PLANS**

 

**Executive Deferred Compensation Plans**

 

As of December 31, 2001, the Company had anExecutive Deferred Compensation Plan whereby management, members of the Boardof Directors and certain highly compensated employees could defer a portion oftheir compensation pursuant to the terms of the plan.  Monies invested through the plan could be withdrawn by therespective individuals at any time, subject to applicable tax laws.  As of December 31, 2002, the plan wasterminated and all amounts were distributed to the respective individuals.

 

In November 2002, the Board approved a newExecutive Deferred Compensation Plan with terms similar to the originalplan.  The Company may also makecontributions to the plan on behalf of the individuals participating in theplan.  A participant is 100% vested incontributions he may make to the plan, with Company contributions vesting at10% per year for the first four years, and 20% per year for the next threeyears.  The Compensation Committee ofthe Board of Directors administers the plan. No amounts have been deferred through December 31, 2002.

 

F-24

----

 

**Stock Incentive Plan**

 

The Company has adopted a Stock IncentivePlan that provides for the granting of options to purchase common stock, awardsof common stock, both restricted and unrestricted, and certain related rightsto eligible 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 in the granting of options and awards of stock.  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 year ended December 31, 2002, the Company recordedcompensation expense of $30,000 in connection with awards of 3,000 shares,these shares have not been issued or distributed.

 

**Employee Stock Purchase Plan**

 

The Company has adopted an Employee StockPurchase Plan (“ESPP”) that provides its employees with the opportunity topurchase shares of its common stock through accumulated payrolldeductions.  It is the Company’sintention to have the ESPP qualify as an employee Stock Purchase Plan underSection 423 of the Internal Revenue Code of 1986, as amended.  The Employee Stock Purchase Plan providesfor a maximum of 150,000 shares.  As ofDecember 31, 2002, the ESPP had not been fully implemented, and no shares hadbeen issued.

 

**Stock for Compensation Plan**

 

The Company has adopted a Stock forCompensation Plan (“SCP”) that provides a means for eligible employees anddirectors to receive shares of the Company’s common stock or restricted shareunits in lieu of cash compensation.  TheSCP provides for a maximum of 500,000 shares of the Company’s common stock tobe used in conjunction with this plan. Cash bonuses of $522,980 had been earned by individuals, who then wereawarded shares of stock in lieu of the cash compensation.  These shares have not yet been distributedto the applicable individuals.

 

**Defined Contribution Plan**

 

The Company has a 401(k) plan for employeeswho meet certain eligibility requirements. The plan permits a specified percentage of an employee’s salary to bevoluntarily contributed on a pre-tax basis, with a Company matching feature.  Participants may contribute from four to 12percent of eligible earnings to various self-directed investment funds.  The plan provides for Company matchingcontributions at 2-for-1 for the first four percent of an employee’scontribution, and then 1-for-1 up to a maximum of 12%.  Company contributions aggregated $481,000,$331,000 and $474,000 for the year ended December 31, 2002, nine months endedDecember 31, 2001, and year ended March 31, 2001.

 

**Other Postretirement Benefits**

 

The Company provides continued major medicaland life insurance coverage to retired employees and their dependents. The costto maintain such benefits for the year ended December 31, 2002, nine monthsended December 31, 2001, and the year ended March 31, 2001, totaled $858,000,$227,000, and $219,000, respectively.

 

F-25

----

 

The funded status of the plan and the amountsrecognized on the balance sheet as of December 31, 2002 and 2001 are as follows(in thousands):

 
|                                                                                                |   | **DECEMBER 31,** |   |
|-----------------------------------------------------------------------------------------------------|--------|------------------|--------|
|                                                                                                |   | **2002**         |   | **2001** |   |
| Accumulated Postretirement  Benefit Obligation (APBO):                                              |   |             |   |   |   |
| Actives not yet eligible                                                                            |   | $                | 1,985  |   | $ | 1,651 |   |
| Actives fully eligible                                                                              |   | 724              |   | 207 |   |
| Retirees and dependents                                                                             |   | 4,854            |   | 1,444 |   |
| Total APBO                                                                                          |   | 7,563            |   | 3,302 |   |
| Plan assets at fair value                                                                           |   | —           |   | — |   |
| Accrued postretirement benefit  liability                                                           |   | 7,563            |   | 3,302 |   |
| Unrecognized loss from past  experience different from that assumed and from changes in assumptions |   | (4,695           | )      | (606 | ) |
| Accrued postretirement benefit  cost                                                                |   | $                | 2,868  |   | $ | 2,696 |   |

 

Changes in the accrued postretirement benefitcost for the year ended December 31, 2002, nine months ended December 31, 2001,and the year ended March 31, 2001, are as follows (in thousands):

 
|                              |   | **DECEMBER 31,** |   | **MARCH 31,** |   |
|-----------------------------------|--------|------------------|--------|---------------|--------|
|                              |   | **2002**         |   | **2001**      |   | **2001** |   |
| Balance, beginning of  period     |   | $                | 2,696  |          | $      | 2,629 |   | $ | 2,539 |   |
| Net periodic  postretirement cost |   | 858              |   | 356           |   | 339 |   |
| Contributions                     |   | (686             | )      | (289          | )      | (249 | ) |
| Balance, end of period            |   | $                | 2,868  |          | $      | 2,696 |   | $ | 2,629 |   |

 

Net periodic postretirement benefit costs forthe year ended December 31, 2002, nine months ended  December 31, 2001, and the year ended March 31, 2001 are asfollow  (in thousands):

 
|                             |   | **DECEMBER 31,** |   | **MARCH 31,** |   |
|----------------------------------|--------|------------------|--------|---------------|--------|
|                             |   | **2002**         |   | **2001**      |   | **2001** |   |
| Service cost                     |   | $                | 148    |          | $      | 128 |   | $ | 125 |   |
| Interest cost                    |   | 471              |   | 228           |   | 214 |   |
| Amortization of  experience loss |   | 239              |   | —        |   | — |   |
|                             |   | $                | 858    |          | $      | 356 |   | $ | 339 |   |

 

The assumption used in the calculation of thecosts presented above were as follows:

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

 

Health care cost trend rates: Medical anddental 10% in 2003, grading down 1.0% per year to an ultimate rate of 5% forall years beginning in 2008.

 

Increasing the assumed healthcare cost trendrates by one percentage  point in theyear ended December 31, 2002, nine months ended December 31, 2001, and the yearended March 31, 2001, would increase the APBO $1,310,000, $430,000 and  $384,000, respectively, and the aggregate ofthe service and interest cost components by $130,000, $51,000 and $47,000, respectively.

 

F-26

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No return on plan assets was assumed in the calculationas the Company holds no specified plan assets.

 

**20. DEFERRED CREDITS**

 

Deferred credits at December 31, 2002 and2001, consisted of the following (in thousands):

 
|                                          |   | **DECEMBER 31,** |   |
|-----------------------------------------------|--------|------------------|--------|
|                                          |   | **2002**         |   | **2001** |   |
| Post retirement benefits  (Note 19)           |   | $                | 2,868  |   | $ | 2,696 |   |
| Deferred executive  compensation (Note 19)    |   | 3                |   | 828 |   |
| Long-term equity  redemption credits (Note 2) |   | —           |   | 368 |   |
| Unclaimed member capital  credits             |   | 68               |   | 36 |   |
| Deferred revenue                              |   | 2,182            |   | 1,252 |   |
| Other                                         |   | 73               |   | 141 |   |
| Total Deferred credits                        |   | $                | 5,194  |   | $ | 5,321 |   |

 

Deferred revenue relates to purchased powercost expensed in prior years and not billed to customers.  Rates billed in prior periods were Boardapproved rates.  Purchased power fromprior periods was not billed to customers until the timing was approved by theBoard.  Effective January 2002, theCompany recorded $4,364,000 in deferred revenue and a corresponding increase toits purchased power cost recovery received related to recoveries of purchasedpower costs approved by the Board.  Thedeferred revenues are being recovered from customers on a monthly basis over a24 month period from January of 2002 to December of 2003.  During 2002, the Company billed andrecognized $2,182,000 of deferred revenue. The balance of deferred revenue at December 31, 2002, is $2,182,000 andwill be recognized in 2003.

 

Unclaimed member capital credits are relatedto capital credit distribution payments made by the Cooperative to its membersprior to 1998 that were returned by the postal service as undeliverable and whichthe Cooperative, after diligent efforts, has been unable to locate.

 

**21. MAJOR CUSTOMERS AND SUPPLIERS**

 

For the year ended December 31, 2002, ninemonths ended December 31, 2001, and the year ended March 31, 2001, the Companyand its subsidiaries had no customer that accounted for more than 10% ofoperating revenues.

 

The Company has outsourced its materialswarehousing function to an outside third party.  The terms of the contract provide that the third-party maintainan adequate inventory level of distribution type components, with after hoursstaffing in case of emergencies.  TheCompany believes that in the event the contract with the third-party should notbe renewed, the Company’s operations would not be severely affected because newcontracts could be secured at competitive rates.

 

**22. REGULATORY MATTERS**

 

Under the Public Utility Regulatory Act of1995 (the “Act”), the Cooperative had elected not to operate under theregulatory authority of the Public Utility Commission of Texas. In accordancewith the Act, any changes in the Cooperative’s electric rates must be approvedby its Board of Directors.  See alsoNote 26.

 

**23. ELECTRIC DEREGULATION**

 

On May 27, 1999, the Texas legislature passeda bill relating to the restructuring of the electric utility industry in Texas.The bill, among other things, froze rates for most of the investor-ownedutilities until retail competition began January 1, 2002, then mandated a 6%rate decrease for residential and small commercial customers. Rates will becapped for five years. Municipally owned utilities and cooperatives may elect,but are not required, to offer retail customer choice

 

F-27

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on or after January 1, 2002. The Company is presently regulated as acooperative. However, the Intervenors in the proceeding for the transfer of theCooperative’s certified territory to the Company have challenged that status.See Note 26.  At the present time, theBoard of Directors have elected to opt out of deregulation and delayparticipation in retail competition until there is more certainty concerningthe various aspects.

 

Under the 1999 law, electric cooperativeselecting to participate in customer choice shall have the right to offerelectric energy and related services at unregulated prices directly to retailcustomers who have customer choice without regard to geographical location.Electric cooperatives electing not to participate in customer choice will notbe permitted to offer electric energy at unregulated prices directly to retailcustomers outside its certified retail service area.

 

**24. RELATED PARTY ACTIVITY**

 

As described in Note 9, during the year endedMarch 31, 2001, New West and its board of directors entered into a series oftransactions whereby each contributed mineral interests to MAP, and both NewWest and its board of directors received stock of MAP, New West received a notereceivable from MAP, and the directors received options to purchase additionalshares of MAP common stock.  On June 19,2001, all of the Map common stock options were exercised by the directors whichreduced New West’s interest in Map from approximately 49% to approximately 42%.

 

In October 1992, the Cooperative entered intoan Achievement Based Contract—Southwestern Public Service Company (“ABC-SPSContract”) with its executive officers and a former employee, a total of fourindividuals. In accordance with the terms of the ABC-SPS Contract, thecompensation distributed to the individuals equals 2% of the annual netpurchased power cost savings derived from the SPS purchased power contractcompared to the prior Texas Utilities purchased power contract and the powersupply agreements for the Hunt-Collin division. The compensation is computed asof the end of each calendar year based on an assessment of the estimatedsavings and approved by the Compensation Committee. For the year ended December31, 2002, and the nine months ended December 31, 2001, compensationattributable to the contract was approximately $156,000 and $48,000, which amountshave not been paid, but are shown as a liability on the consolidated balancesheet.  For the year ended March 31,2001, $124,000 was paid pursuant to the contract.  The ABC-SPS Contract, which had been assumed by the Company, willexpire in 2003.

 

In June 1999, the Cooperative entered into anAchievement Based Compensation Contract—Merger or Acquisition With OtherElectric Utilities (the “ABC-Merger Contract”) with certain of its executiveofficers, its general counsel and its directors and advisory directors, a totalof 16 individuals.  The ABC-MergerContract was amended in 2000.  Inaccordance with the terms of the ABC-Merger Contract, the participants receivecompensation equal to 1.5% of the total assets added to the Cooperative orEnergy by merger or acquisition since 1990. Total assets added means only thosemergers or acquisitions of electric or telephone cooperatives or municipalelectric systems that require only the assumption of debt and equity. Amountspaid under the ABC-Merger Contract are allocated 60% to participating executiveofficers, 10% is allocated to the general counsel and 30% is allocated todirectors and advisory directors.  Noamounts were accruable under the ABC-Merger Contract for the year endedDecember 31, 2002, nine months ended December 31, 2001, or for the year endedMarch 31, 2001.  The ABC-MergerContract, which has been assumed by the Company, expires in August 2010.

 

In August 2001, the Cooperative entered intoan Achievement Based Compensation Contract-Power Transmission Contract(“ABC-Power Transmission Contract”) involving its executive officers, directorsand a former director.  The Company hasassumed the ABC-Power Transmission Contract. In accordance with the terms of the ABC-Power Transmission Contract, theparticipants will receive compensation equal to 1.0% of the net profit or netcapital acquired by the Cooperative or Energy in connection with the sale orleaseback of the transmission system if payment is taken in cash or 2.0% ifpayment is taken in the form of stock of the Company.  Payment will be deferred until the earlier of 2003 or new equityis raised by the Company in the amount of $5 million or more.  Amounts paid under the ABC-PowerTransmission Contract are allocated 60% to the executive officers and theremaining 40% is allocated equally to each of the directors and the formerdirector.  No amounts have been paid oraccrued under the ABC-Power Transmission Contract.

 

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**25. OTHER SHAREHOLDER MATTERS**

 

The Cap Rock Energy Corporation Shareholders’Trust (the “Trust”) was established by the Company in October 2002, on behalfof former members of the Cooperative whose current addresses are unknown andwould have received shares of common stock in connection with the conversion ofthe Cooperative into the Company.  Theshared authority of the two Trustees of the Trust is to make distribution ofstock to beneficial owners when they have been located.  As of December 31, 2002, there were 344,171shares of stock held beneficially by the Trust.  Other powers are limited to those granted in the Trust document,the Share Option Agreement and the Funding Agreement.

 

The Trust provides that in the case of atender offer or other repurchase offer by the Company for shares of the capitalstock of the Company, the Trustees may, in their sole discretion and actingjointly in the best interest of the beneficiaries of the Trust, sell all of theshares held in the Trust to the Company at the highest cash price offered underthe tender offer or other repurchase offer. If the tender offer by the Company has a premium of 25% or more, theTrustees shall sell all of 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.

 

The Funding Agreement between the Trust andthe Company provides that the Trustees may request funds from the Company topay for compensation and expenses of the Trustees in connection with theirduties and responsibilities as Trustees of the Trust.  In the event the Company fails to fulfill its obligations underthe Funding Agreement, the Trustees may sell such shares as are necessary forthe Trust to pay such compensation and expenses.  The Company transferred less than $1,000 to the Trust in 2002 topay for the Trustees’ costs and expenses.

 

The Share Option Agreement grants the Companythe right to acquire all of the shares held by the Trust that would otherwiseescheat to the State of Texas.  TheTrustees must notify the Company of their intent to escheat such shares, andthe Company then has the right to purchase those shares at the average marketprice for 30 trading days before the Company exercises its right under theagreement.  The shares would not escheatuntil 2005.

 

**26. COMMITMENTS AND CONTINGENCIES**

 

The Company purchases all of its electricpower pursuant to long-term wholesale electric power contracts withSouthwestern Public Service Company (“SPS”), Lower Colorado River Authority(“LCRA”) and Garland Power and Light (“Garland”). SPS, LCRA and Garlandcontracts expire in 2013, 2016 and 2004, respectively, and account forapproximately 72%, 13% and 15%, respectively, of the Company’s electric powerpurchases. The contracts for power cover kWh usage, kW demand levels,transmission, scheduling and ancillary services along with energy and fuelcosts. The Company’s purchased power costs fluctuate primarily with the priceof the fuel and usage. Management believes that in the event the contracts arenot renewed, the Company’s operations will not be severely affected as newcontracts can be secured at competitive rates with other electric powerproviders.

 

The Company’s West Texas division is suppliedpower through a contract with SPS. The SPS contract has no minimum kWh usagerequirements, but does have minimum charges for kW demand and transmissionservices. The Company must pay a minimum of 65% of the prior twelve monthshighest monthly kW demand usage multiplied by a fixed rate along with theirpro-rata share of the fixed transmission costs based on the Company’s priortwelve months usage as a percentage of all SPS usage. The SPS contract allowsthe Company to purchase all power needed. Energy, kW demand, ancillary servicesand scheduling charges are based on fixed factors charged against usage. TheCompany also pays a pro-rata share of SPS’s FERC regulated transmissioncharges. Fuel costs paid to SPS are based on SPS’s actual cost of fuel used togenerate electricity. The SPS contract expires in December 2013.

 

The LCRA contract covers all power utilizedby the Central Texas division of the Company and permits the Company topurchase 100% of the power needed to supply the native load of the division.LCRA charges the Company fixed factors for energy, kW demand and schedulingservices applied to our usage. LCRA’s transmission charges are fixed

 

F-29

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monthly charges regulated by the Electric Reliability Council of Texas(“ERCOT”). Fuel costs paid to LCRA are the Company’s pro-rata share of theamounts that LCRA actually pays for fuel to generate electricity. The Companyis required to purchase power from LCRA, but has no minimum usage levels andonly minimal penalties. The contract between LCRA and the Company expires inJune 2016.

 

Garland provides all power supplyrequirements, including ancillary and scheduling services, for the NortheastTexas division.  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 theNortheast Texas division of the Company with transmission services. ERCOTregulates the transmission rates that are charged by the ERCOT members. TheCompany pays a fixed monthly fee based on the estimated usage submitted priorto the beginning of each year. There is no contract with the individual ERCOTmembers. Taking power over the ERCOT network requires the Company to pay feesregulated by ERCOT. The annual charges to use the ERCOT transmission networkcover the period from January 1 to December 31 of each year. Withdrawing fromERCOT and using other transmission services relieves the user of furthercharges. Because the use of the network is governed by ERCOT and falls underthe jurisdiction of the Texas Public Utility Commission, a contract is notrequired with each ERCOT member.

 

The Company and the Cooperative filed anapplication to transfer the Cooperative’s certified territory to theCompany.  This was the last step in theconversion process.  Several partiesintervened in that proceeding and they are seeking to stop the transfer of theCCN.  Alternatively, these OpposingIntervenors are requesting a ruling that the Company would be regulated as aninvestor owned utility by the Public Utility Commission of Texas (“PUCT”)rather than as a cooperative.  ThePublic Utility Regulatory Act currently provides that a successor to anelectric cooperative created before June 1, 1999, in accordance with a conversionplan approved by a vote of the members of the electric cooperative, will beconsidered as a cooperative for regulatory purposes.  The Opposing Intervenors argue that the Company does not qualifyfor such treatment and have attacked the validity of the vote of theCooperative’s members that approved the conversion process.  The Opposing Intervenors have also requestedthe PUCT to require the Company to “unwind” the conversion or, if it isdetermined that the conversion cannot be “unwound,” to regulate the Company asan investor owned utility for state regulatory purposes.  As another alternative, the OpposingIntervenors seek to have restrictions placed on the Company if the CCN istransferred.  As a result, until thereis a Final Order by the PUCT on this issue, it is uncertain whether the Companywill be considered a cooperative or an investor owned utility for regulatorypurposes or, if the Company is determined not to be an investor owned utilityfor state regulatory purposes, whether any restrictions will be placed upon theCompany’s operations.

 

A hearing was held before Administrative LawJudges in Austin, Texas in June 2002.  AProposal for Decision (“PFD”) was issued by the Administrative Law Judges onSeptember 25, 2002.  The PFD recommendthat the Company be found to have taken proper steps to qualify for continuedtreatment as a cooperative under PURA. It further recommended that the CCN be transferred.  The PFD also recommended that the Company berequired to comply with certain conditions as part of the transfer of the CCN.Those conditions would require the Company to reduce its general andadministrative expenses to no more than 30% of its gross margins, prohibitionfrom making future acquisitions that are unrelated to providing reliableelectric service to its existing customers, require any acquisitions to firstbe approved by the PUCT, require maintenance of separate books and records forits electric divisions which are distinct from its existing subsidiary andnon-electric operations, and require filing of outage reports under PUCTSubstantive Rules 25.5 and 25.81.

 

The PFD was considered by the PUCT at an openmeeting held on November 7, 2002.  Atthe open meeting, the PUCT made no ruling, but requested the Company andOpposing Intervenors file briefs in response to questions outlined by theCommissioners.  Briefs were filed andmatters were considered by the PUCT at the open meeting held on November 21,2002.  At that meeting, the PUCT made noruling, but requested an opinion from the Attorney General of the State ofTexas as to whether an electric cooperative may convert to a shareholdercorporation by transferring all of its assets and liabilities to a shareholderowned corporation that it had created. The Attorney General has not yet rendered an

 

F-30

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opinion.  Once the opinion fromthe Attorney General has been rendered, the matter will again go before thePUCT for consideration.

 

Senate Bill 1280 (“SB 1280”) is proposedlegislation in the Texas Legislature which, if passed, would amend the PublicUtility Regulatory Act, to treat a successor to an electric cooperative as aninvestor owned utility.  SB 1280 alsoprovides for establishment of schedules and procedures by the PUCT for those successorswhich were not previously subject to regulation as an investor owned utilityprior to September 1, 2003.  Althoughthe bill has passed in committee, it must pass in both the Texas Senate andTexas House of Representatives before it becomes law.

 

Delays in receiving final approval may impactthe Company’s timing and ability to refinance its debt.  The Company cannot predict all potentialramifications that may occur as a result of the passage of SB 1280 orregulation by the PUCT.  While theCompany believes it will ultimately prevail, it is impossible to predict theoutcome of these proceedings or any restrictions that the PUCT may place uponthe Company.

 

In March 2002, the Company received a demandletter from an attorney claiming to represent members or shareholders of theCooperative. Such letter purports to be a derivative action demand underArticle 5.14 section C of the Texas Business Corporation Act. The lettergenerally asserts wrongdoing by the Board and management because the vote atthe October 20, 1998, membership meeting at which the conversion plan wasadopted was not a valid vote. Management is currently evaluating the demand.The Company believes the claims outlined in the letter have no merit.

 

The Company is involved in various otherlitigation matters, none of which is expected to have a material impact on thefinancial condition, operating results or liquidity of the Company.

 

**27. INCOME TAXES**

 

The Cooperative and NewCorp are tax-exemptorganizations under Internal Revenue Code Section 501(c)(12). Energy, Capstar,New West and CRCFC are taxable organizations for Internal Revenue Servicepurposes and file separate federal income tax returns.  For the nine months ended December 31, 2001,and the year ended March 31, 2001, Energy, Cap Star and New West incurred notax liability.

 

The Company accounts for income taxes inaccordance with SFAS No. 109 “Accounting for Income Taxes,” which requires therecognition of a liability or an asset, net of a valuation allowance, for thedeferred tax consequence of all temporary differences between the tax basis andthe reported amounts of assets and liabilities, and for the future benefit ofoperating loss carryforwards.

 

The following is a reconciliation of incometax expense as shown in the consolidated statement of operations for the yearended December 31, 2002:

 
| Income tax expense at  statutory rate (34%)                |   | $      | 3,125   |   |
|------------------------------------------------------------|--------|--------|---------|--------|
| Income from nontaxable  entities                           |   | (1,626 | )  |
| State tax expense                                          |   | 132    |    |
| Increase in operating  loss and other carryovers           |   | (2,680 | )       |
| Change in effective tax  rate of operating loss carryovers |   | (295   | )       |
| Change in valuation  allowance                             |   | 1,599  |    |
| Other                                                      |   | 159    |    |
| Tax expense                                                |   | $      | 414     |   |

 

The following is an analysis of theconsolidated income tax expense for the year ended December 31, 2002 (inthousands):

 
| Current     |   | $      | 414    |   |
|-------------|--------|--------|--------|--------|
| Deferred    |   | — |   |
| Tax expense |   | $      | 414    |   |

 

F-31

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The tax effects of significant temporarydifferences and carryforwards at December 31, 2002, are as follows (inthousands):

 
| Net deferred tax assets  (liabilities): |   |   |   |
|-----------------------------------------|--------|--------|--------|
|                                    |   |   |   |
| Accrued expenses                        |   | $      | 333    |   |
| Allowance for doubtful  accounts        |   | 18     |   |
| Net operating loss  carryforwards       |   | 7,057  |   |
| Total deferred tax  assets              |   |   | 7,408  |   |
|                                    |   |   |   |
| Deferred revenue                        |   | (521   | )      |
| Property and equipment                  |   | (19    | )      |
| Total deferred tax  liabilities         |   |   | (540   | ) |
|                                    |   |   |   |
| Valuation allowance                     |   | (6,868 | )      |
| Net deferred tax asset  (liability)     |   | $      | — |   |

 

In addition to the net deferred tax assets(liabilities) detailed above, there exists a $7.7 million capital losscarryover on a consolidated basis available for future use which expires in2004.

 

As of December 31, 2002, the Company has netoperating tax loss carryforwards of approximately $19.1 million, of whichapproximately $18.5 million are related to subsidiaries not included in theconsolidated income tax return, and $.6 million which are included in theconsolidated income tax return.  The netoperating loss carryforwards are scheduled to expire in 2008 through 2021.  The Company has benefited approximately $1.2million of net operating loss carryforward attributable to one of its subsidiariesbecause it believes it has tax planning strategies available to realize its taxloss carryforwards.  A valuationallowance reduces deferred taxes based on the criteria set forth in SFAS 109.

 

The components of the consolidated netdeferred tax assets and liabilities as of December 31, 2001, are as follows (inthousands):

 
| Deferred tax assets:                |   |   |   |
|-------------------------------------|--------|--------|--------|
| Net operating losses                |   | $      | 5,269  |   |
| Capital loss carryover              |   | 2,718  |   |
| Net deferred tax assets             |   | 7,987  |   |
| Deferred tax  liabilities:          |   |   |   |
| Patronage dividends                 |   | (1,670 | )      |
| Other                               |   | — |   |
| Net deferred tax  liabilities       |   | (1,670 | )      |
|                                |   |   |   |
| Valuation allowance                 |   | (6,317 | )      |
|                                |   |   |   |
| Net deferred tax asset  (liability) |   | $      | — |   |

 

F-32

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**28. SEGMENT INFORMATION**

 

The Company has adopted SFAS No. 131,“Disclosures about Segments of a Business Enterprise and Related Information.”Substantially all of the Cooperative’s operations are conducted in Texas andinvolve the following business segments:

 

Utility—electric sales andvarious electric services;

Other—oil and gas, realestate and other investments; and

Corporate—generalcorporate activities including cash and temporary cash investments, variousnotes receivable, miscellaneous investments and interest expense.

 

Business segment information as of and forthe year ended December 31, 2002, nine months ended December 31, 2001, and theyear ended March 31, 2001, is as follows (in thousands):

 
|                           |   | **UTILITY** |   | **OTHER** |   | **CORPORATE** |   | **TOTAL** |   |
|--------------------------------|--------|-------------|--------|-----------|--------|---------------|--------|-----------|--------|
| Operating revenues             |   |        |   |      |   |          |   |      |   |
| December 31, 2002              |   | $           | 74,202 |      | $      | 435           |   | $         | — |   | $ | 74,637 |   |
| December 31, 2001              |   | 52,769      |   | 353       |   | —        |   | 53,122    |   |
| March 31, 2001                 |   | 71,715      |   | 750       |   | —        |   | 72,465    |   |
| Net income (loss)              |   |        |   |      |   |          |   |      |   |
| December 31, 2002              |   | 15,217      |   | 280       |   | (6,721        | )      | 8,776     |   |
| December 31, 2001              |   | 11,478      |   | 32        |   | (7,080        | )      | 4,430     |   |
| March 31, 2001                 |   | 8,320       |   | (3,873    | )      | (8,628        | )      | (4,181    | )      |
| Identifiable assets            |   |        |   |      |   |          |   |      |   |
| December 31, 2002              |   | 184,778     |   | 4,083     |   | 22,433        |   | 211,294   |   |
| December 31, 2001              |   | 189,456     |   | 4,026     |   | 20,977        |   | 214,459   |   |
| March 31, 2001                 |   | 192,054     |   | 4,397     |   | 24,744        |   | 221,195   |   |
| Capital expenditures           |   |        |   |      |   |          |   |      |   |
| December 31, 2002              |   | 1,517       |   | —    |   | —        |   | 1,517     |   |
| December 31, 2001              |   | 4,257       |   | 76        |   | —        |   | 4,333     |   |
| March 31, 2001                 |   | 9,714       |   | 360       |   | —        |   | 10,074    |   |
| Depreciation and  amortization |   |        |   |      |   |          |   |      |   |
| December 31, 2002              |   | 9,198       |   | 55        |   | —        |   | 9,253     |   |
| December 31, 2001              |   | 8,284       |   | 44        |   | —        |   | 8,328     |   |
| March 31, 2001                 |   | 10,576      |   | 287       |   | —        |   | 10,863    |   |
| Interest expense, net          |   |        |   |      |   |          |   |      |   |
| December 31, 2002              |   | —      |   | —    |   | 7,103         |   | 7,103     |   |
| December 31, 2001              |   | —      |   | —    |   | 8,004         |   | 8,004     |   |
| March 31, 2001                 |   | —      |   | —    |   | 11,832        |   | 11,832    |   |
|                                |        |             |        |           |        |               |        |           |        |  |  |  |  |

 

F-33

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

 

The following table summarizes results foreach of the four quarters in the years ended December 31, 2002 and 2001 (inthousands except per share data):

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

 
|                                          |   | **QUARTER ENDED** |   |
|-----------------------------------------------|--------|-------------------|--------|
|                                          |   | **MARCH 31,**     |   | **JUNE 30,** |   | **SEPTEMBER 30,** |   | **DECEMBER 31,** |   |
| **Period  ended December 2001 (Predecessor)** |   |              |   |   |   |   |   |   |   |
| Total revenues                                |   | $                 | 20,365 |   | $ | 18,150 |   | $ | 21,578 |   | $ | 13,394 |   |
| Operating income                              |   | 2,322             |   | 2,343 |   | 5,909 |   | 1,728 |   |
| Net income (loss)                             |   | (265              | )      | (199 | ) | 4,743 |   | (114 | ) |
| Pro forma net income  (loss) per common share |   | (.20              | )      | (.15 | ) | 3.64 |   | (.09 | ) |
|                                               |        |                   |        |  |  |  |  |  |  |  |  |  |  |

 

The Lamarcombination costs of $1,357,000 were expensed during the quarter ended December31, 2002.

 

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